Series 7 practice questionhardCMOs — Interest-Only and Principal-Only Strips
If interest rates decline, an interest-only (IO) strip from a CMO will most likely:
- AIncrease in value because rates are lower
- BDecrease in value because faster prepayments reduce the outstanding principal on which interest is calculated✓ Correct answer
- CRemain unchanged because the coupon rate is fixed
- DBe called by the issuer at par value
Explanation
Why B — Decrease in value because faster prepayments reduce the outstanding principal on which interest is calculated
Interest-only strips receive only the interest portion of mortgage payments. When interest rates decline, prepayments accelerate as homeowners refinance. This reduces the outstanding principal balance faster, which means less interest is generated for IO holders. IO strips have negative duration — they move in the same direction as interest rates (losing value when rates fall). This makes them unique among fixed-income securities.
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