Explanation:
Prepayment risk is the uncertainty associated with the timing and amount of cash flows from mortgage-backed securities (MBS). This risk arises when borrowers pay off their mortgages earlier than expected, typically in response to declining interest rates. This disrupts the expected cash flow schedule, making it difficult for investors to manage the duration and convexity of their portfolios effectively. Choice A is incorrect because prepayment risk affects reinvestment opportunities at lower, not higher, interest rates. Choice C is incorrect because prepayments accelerate principal return. Choice D is incorrect because prepayment risk is unrelated to credit risk; it pertains to the timing of cash flows rather than the likelihood of default.
(Book 3, Module 44.3, LO 44.h)
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Question 59
Which of the following statements best explains why prepayment risk is particularly challenging for investors in mortgage-backed securities (MBSs)? Prepayment risk:
A
eliminates the possibility of reinvestment at higher interest rates.
B
causes cash flow variability, complicating duration and convexity analysis.
C
guarantees that investors will receive principal payments later than expected.
D
increases the credit risk of MBSs by exposing investors to potential borrower defaults.
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