An investor in a mortgage pass-through security is exposed to prepayment risk, which is the same as one type of risk: extension risk.

Question

Quizplus · Accepted Answer

Prepayment risk and extension risk are related but opposite concepts within mortgage-backed securities. Prepayment risk involves the risk that borrowers will pay off their mortgages earlier than expected, potentially reducing the interest income for investors. Extension risk, on the other hand, is the risk that borrowers will pay off their mortgages slower than expected, extending the duration of the investment and potentially exposing investors to adverse interest rate movements.

An Investor in a Mortgage Pass-Through Security Is Exposed to Prepayment