土豆妮

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

A) increasing interest rates on passthrough securities.

B) lower prepayment rates.

C) declining interest rates on passthrough securities.

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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.

土豆妮

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

A) lower prepayment rates.

B) expected prepayment rates.

C) declining interest rates on passthrough securities.

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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.

土豆妮

Which of the following statements is FALSE regarding prepayment risk?

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

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

C) 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.

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

土豆妮

All of the following are factors that affect prepayments EXCEPT:

A) seasoning.

B) the amount of overall mortgage loan activity in the market.

C) characteristics of underlying mortgage loans.

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The amount of overall mortgage activity does not impact prepayments.