Products & RisksQuestion 48 of 125
Prepayment risk in mortgage-backed securities means that:
a.The issuer will default on interest payments
b.The bonds cannot be sold before maturity
c.Interest rates will always rise
d.When interest rates fall, homeowners refinance and return principal sooner than expected
Explanation
Prepayment risk arises because falling interest rates prompt homeowners to refinance, returning principal to investors earlier than expected. Investors then must reinvest that principal at the new, lower rates, which is a form of reinvestment risk specific to mortgage-backed securities.
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