Series 7 practice questionmediumCMOs — Prepayment Risk
Prepayment risk for mortgage-backed securities is GREATEST when:
- AInterest rates are falling, encouraging homeowners to refinance✓ Correct answer
- BInterest rates are rising sharply
- CThe economy is in a recession
- DHome prices are declining
Explanation
Why A — Interest rates are falling, encouraging homeowners to refinance
Prepayment risk is the risk that mortgage holders will refinance their loans and pay off principal earlier than expected. This risk is greatest when interest rates fall because homeowners can refinance at lower rates. For MBS investors, prepayments mean principal is returned sooner and must be reinvested at lower prevailing rates, reducing overall returns. This is a form of reinvestment risk specific to mortgage-backed securities.
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