LOS c: Describe path dependency in passthrough securities and the implications for valuation models.

Q1. Which of the following statements regarding a mortgage-backed security (MBS) is TRUE?

A)   Backward induction methodology is useful for valuing MBS.

B)   Binomial models should not be used for MBS because of path dependency.

C)   Path dependency means that MBS prices tend to follow a trend.

Q2. Assume that interest rates in the year 2010 decrease below historical averages. They continue their downward trend for years 2011 and 2012. In which year would a MBS be least likely to be experience high rates of prepayment?

A)   2013.

B)   2010.

C)   2012.

Q3. Prepayment burnout in a mortgage-backed security (MBS) refers to the fact that:

A)   some tranches will experience extreme rates of prepayment.

B)   in the later years of a downward trend in interest rates, less mortgages will be refinanced.

C)   eventually a MBS will exceed the maximum prepayments allowed when interest rates drop too low.

LOS c: Describe path dependency in passthrough securities and the implications for valuation models. fficeffice" />

Q1. Which of the following statements regarding a mortgage-backed security (MBS) is TRUE?

A)   Backward induction methodology is useful for valuing MBS.

B)   Binomial models should not be used for MBS because of path dependency.

C)   Path dependency means that MBS prices tend to follow a trend.

Correct answer is B)

In a MBS, whether a mortgage is called depends on the path of previous interest rates. If rates had been low previously, then mortgages are less likely to be called later on. Thus a binomial model that uses backward induction methodology (later outcomes are determined first) should not be used to value MBS.

Q2. Assume that interest rates in the year 2010 decrease below historical averages. They continue their downward trend for years 2011 and 2012. In which year would a MBS be least likely to be experience high rates of prepayment?

A)   2013.

B)   2010.

C)   2012.

Correct answer is C)

In a mortgage-backed security (MBS), whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Thus fewer mortgages will be refinanced in the year 2012 than in the earlier years.

Q3. Prepayment burnout in a mortgage-backed security (MBS) refers to the fact that:

A)   some tranches will experience extreme rates of prepayment.

B)   in the later years of a downward trend in interest rates, less mortgages will be refinanced.

C)   eventually a MBS will exceed the maximum prepayments allowed when interest rates drop too low.

Correct answer is B)

In a MBS, whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Prepayment burnout means that eventually mortgage refinancing will slow in the later stages of a downward trend in interest rates.

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