Mortgage Pass Through Securities 2

Question 1

What is a mortgage pass-through security?

Answer 1

A mortgage pass-through security is a type of asset-backed security that represents a claim on the cash flows from a pool of mortgage loans.

Question 2

True or False: Mortgage pass-through securities exhibit positive convexity.

Answer 2

False: Mortgage pass-through securities exhibit negative convexity.

Question 3

What does negative convexity imply for mortgage pass-through securities?

Answer 3

Negative convexity implies that as interest rates fall, the price of the security may not increase as much as it would for a standard bond, and vice versa when rates rise.

Question 4

Fill in the blank: Yield uncertainty in mortgage pass-through securities is primarily due to __________.

Answer 4

prepayment risk.

Question 5

What factors can influence prepayment speeds in mortgage loans?

Answer 5

Interest rates, borrower credit quality, housing market conditions, and loan characteristics can influence prepayment speeds.

Question 6

True or False: Higher interest rates typically lead to higher prepayment speeds.

Answer 6

False: Higher interest rates typically lead to lower prepayment speeds.

Question 7

What is the impact of prepayment on the yield of a mortgage pass-through security?

Answer 7

Prepayment can lead to a reduction in yield due to the return of principal before maturity, potentially at less favorable rates.

Question 8

Define ‘prepayment speed estimate’ in the context of mortgage securities.

Answer 8

Prepayment speed estimate refers to the projected rate at which borrowers are expected to repay their mortgages early.

Question 9

What is the significance of the Public Securities Association (PSA) model?

Answer 9

The PSA model is a standard used to estimate prepayment speeds based on a benchmark that assumes a gradual increase in prepayment speeds over time.

Question 10

How does a rise in home equity affect prepayment speeds?

Answer 10

A rise in home equity generally leads to higher prepayment speeds as borrowers may refinance or move.

Question 11

What is ‘yield spread’ in the context of mortgage pass-through securities?

Answer 11

Yield spread refers to the difference in yield between mortgage pass-through securities and benchmark interest rates, reflecting the risk premium.

Question 12

True or False: Investors in mortgage pass-through securities are completely insulated from interest rate risks.

Answer 12

False: Investors are exposed to interest rate risks due to the negative convexity and prepayment risks.

Question 13

What is the effect of negative convexity on duration?

Answer 13

Negative convexity can lead to an increase in effective duration, making the security more sensitive to interest rate changes.

Question 14

What role does credit quality play in prepayment risk?

Answer 14

Higher credit quality borrowers are more likely to prepay when rates decline, increasing prepayment risk for investors.

Question 15

Multiple choice: Which of the following factors does NOT affect prepayment speeds? A) Interest rates B) Economic conditions C) Security type D) Loan characteristics

Answer 15

C) Security type

Question 16

What is the primary risk associated with investing in mortgage pass-through securities?

Answer 16

The primary risk is prepayment risk, which can lead to yield uncertainty.

Question 17

Fill in the blank: When interest rates fall, the likelihood of __________ increases.

Answer 17

prepayment.

Question 18

How can investors mitigate the risks associated with negative convexity?

Answer 18

Investors can diversify their portfolios, use hedging strategies, or invest in securities with more favorable convexity characteristics.

Question 19

What is a ‘constant prepayment rate’ (CPR)?

Answer 19

CPR is a measure used to estimate the percentage of the outstanding pool of loans that are expected to be prepaid in a given period.

Question 20

True or False: Prepayment rates are typically constant over time.

Answer 20

False: Prepayment rates can vary significantly over time due to economic conditions and interest rate changes.

Question 21

What is a ‘collateralized mortgage obligation’ (CMO)?

Answer 21

A CMO is a type of mortgage-backed security that contains a pool of mortgages and is divided into different tranches with varying risk profiles.

Question 22

Name one method used to estimate prepayment speeds.

Answer 22

One method is the use of historical prepayment data to create predictive models.

Question 23

What does it mean for a mortgage security to have ‘extension risk’?

Answer 23

Extension risk refers to the risk that the security will be repaid more slowly than expected, often occurring in rising interest rate environments.

Question 24

What is the relationship between mortgage rates and refinancing activity?

Answer 24

When mortgage rates decrease, refinancing activity typically increases as borrowers seek to lower their payments.