Reading 56: Mortgage-Backed Sector of the Bond Market Los j~Q

investment, mortgage, market, price, rates

LOS j: Explain the investment characteristics of stripped mortgage-backed securities.

Q1. How is the price of a principal-only mortgage strip affected by declining mortgage rates in the market? The price of the principal-only strip:

A) decreases.

B) is unaffected.

C) increases.

Q2. Interest only (IO) strip cash flow:

A) are the same throughout the life of the security.

B) starts out big and gets smaller over time.

C) starts out small and gets bigger over time.

Q3. Richard Myers, CFA, diversifies his client’s fixed income portfolio into different types of mortgage-backed securities (MBS). He is now building a portfolio and has forecasted a scenario of rising interest rates over the planning horizon. His assistant has prepared a graph depicting the relationship between mortgage interest rates (low at the origin, higher going out to the right) and prices for three different types of MBS labeled as A, B, and C.

Letter A represents which type of MBS?

A) Principal-only strip.

B) Interest-only strip.

C) Passthrough.

Q4. Letter B represents which type of MBS?

A) Passthrough.

B) Interest-only strip.

C) Principal-only strip.

Q5. Letter C represents which type of MBS?

A) Passthrough.

B) Interest-only strip.

C) Principal-only strip.

Q6. Myers is also considering collateralized mortgage obligation (CMO) tranches for his client. His assistant has developed the following graph depicting the relationship between types of CMO tranches and risk.

Tranche	Risk Type #1	Risk Type #2
A (sequential pay)	HIGHEST	LOWEST
B (sequential pay)	HIGH	LOW
C (sequential pay)	MEDIUM	MEDIUM
D (sequential pay)	LOW	HIGH
Z (accrual)	LOWEST	HIGHEST

Which of the following describes the risks associated with Risk Type #1 and Risk Type #2?

Risk Type #1 Risk Type #2

A) prepayment risk extension risk

B) contraction risk extension risk

C) extension risk contraction risk

Q7. Principal-only strips are:

A) sold at a considerable discount to par.

B) could be sold at a discount or a premium, depending on economic conditions.

C) sold at par.

Q8. Which of the following best describes a stripped mortgage-backed security (MBS)? A stripped MBS is a security:

A) whose distribution of principal and interest has been altered from a pro rata distribution to an unequal distribution.

B) that provides no interest payments.

C) whose distribution of principal and interest has been altered from an unequal distribution to a pro rata distribution.

Q9. Which of the following is most accurate regarding the investment characteristics of a principal-only (PO) mortgage strip?

A) The slower the prepayments the higher the investor's return.

B) The faster the prepayments the higher the investor's return.

C) The lower the coupon the higher the investor's return.

Q10. How is the price of an interest-only mortgage strip affected by declining mortgage rates in the market below the contract rate? The price of the interest-only strip:

A) may increase or decrease.

B) decreases.

C) increases.