Reading 58: LOS f ～ Q 11- 13

11.Which of the following statements is FALSE regarding prepayment risk?

A)   Contraction risk refers to the shortening of the expected life of the mortgage pool due to falling interest rates.

B)   Reinvestment rate risk is a result of rising interest rates.

C)   Extension risk occurs when interest rates rise.

D)   Investor in mortgage-backed securities must reinvest at lower rates when rates fall and borrowers prepay and are "stuck" with lower rates when rates rise and borrowers hold onto their mortgages.

The correct answer was B)

Reinvestment rate risk is a result of falling interest rates, not rising rates.

12.Which of the following is the best definition of contraction risk? The adverse consequences of:

A)   lower prepayment rates.

B)   declining interest rates on passthrough securities.

C)   expected prepayment rates.

D)   increasing interest rates on passthrough securities.

The correct answer was B)

A decrease in interest rates will give borrowers an incentive to prepay the loan and refinance the debt at a lower rate. Therefore, the maturity of the passthrough will contract. The second adverse consequence is that the cash flows resulting from prepayments have to be reinvested at a lower interest rate.

13.Which of the following is the best definition of extension risk? The adverse consequences of:

A)   lower prepayment rates.

B)   increasing interest rates on passthrough securities.

C)   higher prepayment rates.

D)   declining interest rates on passthrough securities.

The correct answer was B)

Increasing interest rates will slow prepayments resulting in extending the maturity of the passthrough. This reduces the amount available to be invested at the currently high interest rates.