Answer: contraction risk.

## Explanation This question tests understanding of prepayment risks in mortgage-backed securities (MBS), specifically mortgage pass-through securities. **Key Concepts:** 1. **Average Life**: The weighted average time until principal is returned to investors in a mortgage-backed security. 2. **Prepayment Risks**: - **Contraction Risk**: The risk that prepayments will occur faster than expected, shortening the average life of the security. This typically happens when interest rates fall, and homeowners refinance their mortgages. - **Extension Risk**: The risk that prepayments will occur slower than expected, lengthening the average life of the security. This typically happens when interest rates rise, and homeowners are less likely to refinance. - **Balloon Risk**: Typically refers to the risk associated with balloon mortgages where a large payment is due at maturity. **Analysis:** - The average life decreased from 5 years to 2 years over 6 months - This represents a significant shortening of the security's duration - A decrease in average life indicates faster-than-expected prepayments - Faster prepayments occur when interest rates fall, allowing homeowners to refinance at lower rates **Why C is Correct:** The shortening of average life from 5 years to 2 years indicates **contraction risk** - investors received their principal back faster than expected, which is problematic for investors who were counting on longer-term cash flows, especially if they need to reinvest at lower prevailing interest rates. **Why Other Options are Incorrect:** - **A (Balloon Risk)**: Not applicable here as this refers to a specific type of mortgage structure, not prepayment behavior. - **B (Extension Risk)**: This would be the opposite scenario - if average life increased rather than decreased. **Real-World Context:** This scenario is typical when interest rates decline significantly. Mortgage pass-through security investors face reinvestment risk when they receive principal earlier than expected and must reinvest at lower prevailing rates.

Author: LeetQuiz .