SIE practice questionmediumMortgage-Backed Securities
An investor in mortgage-backed securities (MBS) faces which unique risk when interest rates decline?
- ADefault risk
- BCurrency risk
- CPrepayment risk✓ Correct answer
- DInflation risk
Explanation
Why C — Prepayment risk
When interest rates fall, homeowners refinance their mortgages at lower rates, causing early repayment of the underlying loans. MBS investors then receive principal back sooner than expected and must reinvest at lower prevailing rates. This prepayment risk is the primary unique risk of MBS. While default risk exists (A), it is not unique to falling rate environments.
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