CFA Level II ExamFixed IncomeHard
An investor owns a portfolio of mortgage-backed securities (MBS) and is concerned about the impact of rising interest rates. In a rising interest rate environment, which of the following risks is most likely to affect the investor's MBS portfolio?
- APrepayment risk, leading to faster-than-expected principal repayment.
- BExtension risk, leading to slower-than-expected principal repayment.
- CCredit risk, due to increased likelihood of borrower default.
- DReinvestment risk, as prepayments are reinvested at higher rates.
Show answer & explanationAnswer & explanation
Correct answer: B. Extension risk, leading to slower-than-expected principal repayment.
In a rising interest rate environment, homeowners are less likely to refinance their mortgages because new mortgage rates would be higher than their existing ones. This slows down the rate of prepayments, causing the effective maturity of the MBS to extend beyond the original expectation. This phenomenon is known as extension risk.
Why the other options are wrong
- A. Prepayment risk is associated with falling interest rates, where borrowers refinance faster, reducing the MBS's effective maturity.
- C. While rising rates can increase overall credit risk in the economy, the most direct and specific risk to *MBS* in a rising rate environment is related to prepayment behavior, not necessarily an immediate surge in defaults on the underlying mortgages.
- D. Reinvestment risk is typically associated with *falling* interest rates, where prepayments are reinvested at lower yields. In a rising rate environment, reinvestment at higher rates would be beneficial, not a risk in the negative sense described.
Extension Risk
Extension risk is the risk that the average life of a mortgage-backed security (MBS) will lengthen due to a decrease in the rate of prepayments by borrowers, typically occurring in a rising interest rate environment.
- Occurs when interest rates rise, making refinancing less attractive.
- Causes the effective maturity of the MBS to extend.
- Detrimental to MBS investors as cash flows are received later than anticipated, often at below-market rates.
Memory trick: Rates rise, loans extend, prepayments suspend.