Securitization: ABS and MBS: practice question
Tarnfield Savings holds a pool of fully amortising residential loans whose borrowers may repay principal early at par without penalty. If market interest rates fall well below the loans' contract rates, Tarnfield will most likely:
- receive principal faster than scheduled but be no worse off, because earlier cash can only benefit the fund
- keep receiving exactly the scheduled payments, because market yields cannot change a loan's amortisation schedule
- receive principal faster than scheduled and be forced to reinvest it at the new, lower rates
Show answer and explanation
Correct answer: C
Explanation: When market rates fall below the loans' contract rates, borrowers prepay and refinance, so principal arrives ahead of schedule precisely when new lending pays least; having to redeploy the accelerated principal at the new, lower rates is prepayment risk on an amortising pool. The no-worse-off choice counts the early cash but ignores that it arrives to be reinvested at reduced yields, so the fund's interest income still falls. The unchanged-payments choice is right only about the printed schedule: the borrowers' prepayment option, not the schedule, determines the payments the pool actually makes.
More Fixed Income practice Try a mock exam
More free Fixed Income questions
- Peltarine Energy has issued an inverse floating-rate note whose coupon rate each period equals…
- The managers of a scholarship fund buy newly issued 12-year zero-coupon bonds of Windmere Telecom,…
- A 6% semiannual-pay bond issued by Corvale Bank pays 3.00 per 100 of par each period and is quoted…
- A bond of Pellworth Communications matures in exactly seven years and yields 6.12%. On-the-run…