Products & Their RisksQuestion 157 of 398
An investor in a GNMA pass-through security is most exposed to prepayment risk when:
a.Interest rates rise and homeowners hold their mortgages longer
b.The issuer defaults on the underlying loans
c.Interest rates fall and homeowners refinance their mortgages early
d.The bond reaches its stated final maturity
Explanation
Prepayment risk is the danger that homeowners will pay off their mortgages early, returning principal to investors sooner than expected. This happens most when interest rates fall and borrowers refinance at lower rates. The investor then must reinvest the returned principal at the new, lower prevailing rates, reducing expected income.
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