CFA Level II ExamFixed IncomeEasy
An investor holds a portfolio of mortgage-backed securities (MBS) and is concerned about prepayment risk. Which of the following scenarios would most likely increase the prepayment risk for a pool of MBS?
- AA significant increase in market interest rates.
- BA decline in housing prices across the underlying collateral.
- CA widespread economic recession leading to job losses.
- DA sustained period of decreasing market interest rates.
Show answer & explanationAnswer & explanation
Correct answer: D. A sustained period of decreasing market interest rates.
Prepayment risk in MBS increases when homeowners are incentivized to refinance their mortgages. A sustained period of decreasing market interest rates makes refinancing at lower rates attractive, leading to higher prepayments.
Why the other options are wrong
- A. Incorrect. Higher interest rates typically reduce refinancing incentives, thus decreasing prepayment risk.
- B. Incorrect. A decline in housing prices can make it harder for homeowners to refinance (e.g., if they are underwater), thus decreasing prepayment risk.
- C. Incorrect. Economic recession and job losses can lead to defaults, but not necessarily prepayments through refinancing. It can even make refinancing harder.
Prepayment Risk (MBS)
Prepayment risk is the risk that mortgage borrowers will pay off their loans earlier than expected, often due to falling interest rates or home sales, which negatively affects MBS investors.
- Occurs when homeowners refinance or sell their homes.
- Most significant when interest rates decline.
- Results in reinvestment risk for MBS investors at lower yields.
Memory trick: Prepayments 'rush in' when rates 'drop down'.