"Fixed Income": Introduction to Asset-Backed Securities

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Questions 1:

An investor who owns a mortgage pass-through security is exposed to contraction risk,which is the risk that when interest rates:

A 、decline, the security will effectively have a longer maturity than was anticipated at the time of purchase.

B 、decline, the security will effectively have a shorter maturity than was anticipated at the time of purchase.

C 、rise, the security will effectively have a shorter maturity than was anticipated at the time of purchase.

Questions 2:

How much will the value of a three-year $100 par value coupon bond with annual payments, a coupon rate of 9%, and a discount rate of 7% most likely change if market interest rates immediately increase by 1%?

A 、–2.68

B、 –3.47

C、 –2.40

View answer resolution

【Answer to question 1】B

【analysis】

B is correct. Contraction risk is the risk faced by investors when interest rates fall in that the security will effectively have a shorter maturity than was anticipated at the time of purchase because homeowners can refinance at new, lower interest rates.

A is incorrect because contraction risk is the risk faced by investors when interest rates fall in that the security will effectively have a shorter, not longer, maturity than was anticipated at the time of purchase because homeowners can refinance at new, lower interest rates.

C is incorrect because contraction risk is the risk faced by investors when interest rates fall, not rise, in that the security will effectively have a shorter maturity than was anticipated at the time of purchase because homeowners can refinance at new, lower interest rates.

【Answer to question 2】A

【analysis】