QFC Financial Engineering & Structured Products 2

Question 1

What is 'prepayment risk' in the context of mortgage-backed securities (MBS)?

Accepted Answer

The risk that borrowers repay mortgages faster than expected, forcing reinvestment at lower rates

Answer

Prepayment risk arises when homeowners refinance or sell their homes early, returning principal to MBS investors sooner than expected — most harmful when rates have fallen and reinvestment rates are lower.

Question 2

What is a Collateralized Mortgage Obligation (CMO) and why was it created?

Accepted Answer

A structured MBS that redistributes prepayment risk across multiple maturity tranches

Answer

A CMO divides mortgage pool cash flows into tranches with different prepayment characteristics, allowing investors to select exposures that better match their risk tolerance and maturity preferences.

Question 3

What distinguishes 'agency MBS' from 'non-agency MBS'?

Accepted Answer

Agency MBS carry an explicit or implicit government guarantee; non-agency MBS do not

Answer

Agency MBS are issued or guaranteed by GSEs (Fannie Mae, Freddie Mac) or Ginnie Mae, providing protection against credit losses, while non-agency MBS rely solely on the underlying loans' creditworthiness.

Question 4

In MBS analysis, what does the Conditional Prepayment Rate (CPR) measure?

Accepted Answer

The annualized fraction of the remaining mortgage pool that is prepaid in a given period

Answer

CPR expresses on an annualized basis the percentage of the outstanding mortgage pool that is prepaid in a given period, serving as the key metric for modeling MBS cash flows and duration.

Question 5

What causes 'negative convexity' in mortgage-backed securities?

Accepted Answer

MBS price appreciation slows as rates fall because accelerating prepayments shorten duration

Answer

MBS exhibit negative convexity because when rates fall, prepayments accelerate and duration shortens, capping price appreciation relative to a comparable straight bond and causing a concave price-yield relationship.

(QFC) Quantitative Finance Certification Practice Test

(QFC) Quantitative Finance Certification Practice Test

QFC Financial Engineering & Structured Products 2