Chapter 18 - Mortgage and Mortgage Backed Securities (FRM Part 1 - Book 3)
Chapter 18 - Mortgage and Mortgage Backed Securities
Chapter 18 - Mortgage and Mortgage Backed Securities
1. What is the typical term of a conventional mortgage?
A. 5 to 10 years
B. 10 to 15 years
C. 15 to 30 years
D. 5 to 20 years
A conventional mortgage typically lasts for 15 to 30 years.
2. What is one of the main reasons for the increased issuance of mortgage loans in recent decades?
A. Lower interest rates
B. Increased government regulation
C. A reduction in the number of lenders
D. The rise of the secondary market through securitization
The secondary market, through securitization, has allowed more banks to issue mortgage loans.
3. Which type of mortgage has a fixed interest rate for the entire term?
A. Fixed-rate mortgage
B. Adjustable-rate mortgage
C. Hybrid mortgage
D. Interest-only mortgage
A fixed-rate mortgage has a set rate of interest for the term of the mortgage.
4. What type of mortgage involves interest rate changes throughout the term?
A. Fixed-rate mortgage
B. Adjustable-rate mortgage (ARM)
C. Balloon mortgage
D. Reverse mortgage
Adjustable-rate mortgages (ARMs) have rate changes throughout the term, typically based on a base rate plus a spread.
5. What is a significant risk of default with adjustable-rate mortgages (ARMs)?
A. Low monthly payments
B. Initial rate periods with extremely high interest
C. Large rate increases after the first year
D. Fixed interest rate for the entire term
The risk of default is high if there are large rate increases after the first year of an adjustable-rate mortgage (ARM).
6. What is the structure of a typical Mortgage-Backed Security (MBS) in the secondary market?
A. The borrower receives payments directly
B. The payments go directly to the bank that issued the mortgage
C. The interest and principal pass through the banks to the MBS investor
D. The bank retains all payments from the borrower
In a typical MBS, the interest and principal payments from the borrower pass through the banks and ultimately reach the MBS investor.
7. What type of loans are required for the creation of Mortgage-Backed Securities (MBS)?
A. Loans without any credit guarantees
B. Loans with credit guarantees
C. Only government-backed loans
D. Loans with high interest rates
To create MBS, loans must have credit guarantees, often provided by government-sponsored entities (GSEs) or other backing institutions.
8. Which government agencies back government loans that can be securitized into Mortgage-Backed Securities (MBS)?
A. Federal Reserve and Fannie Mae
B. Federal Home Loan Bank and Freddie Mac
C. Fannie Mae and Government National Mortgage Association
D. Government National Mortgage Association (GNMA)
Government loans are backed by federal agencies like the Government National Mortgage Association (GNMA).
9. Which government-sponsored enterprises (GSEs) guarantee conventional loans that can be securitized into MBS?
A. Federal National Mortgage Association (FNMA) and Government National Mortgage Association (GNMA)
B. Federal Housing Finance Agency (FHFA)
C. Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA)
D. Only the Government National Mortgage Association (GNMA)
Conventional loans can be securitized by GSEs such as the Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA).
10. What risk does the investor bear in an Agency Mortgage-Backed Security (MBS)?
A. Credit risk
B. Prepayment risk
C. Interest rate risk
D. Default risk
While Agency MBS investors are protected from credit risk by GSE guarantees, they still bear the risk of prepayments, especially when interest rates are low.
11. What type of Mortgage-Backed Securities (MBS) are issued privately without any guarantee from GSEs?
A. Agency MBS
B. Conforming MBS
C. Nonagency MBS
D. Government-backed MBS
Nonagency MBS are issued privately and do not have any guarantee from government-sponsored enterprises (GSEs).
12. In a fixed-rate mortgage, what happens to the proportion of the monthly payment that goes toward interest over time?
A. The proportion of interest increases over time
B. The proportion of interest decreases over time
C. The proportion of interest stays constant
D. The interest is paid only in the first year
In a fixed-rate mortgage, as time passes, the proportion of the monthly payment that goes toward interest decreases because the interest is calculated on the beginning-of-period outstanding principal.
13. What is the purpose of scheduled amortization in a fixed-rate mortgage?
A. To make interest payments larger as time passes
B. To reduce the loan term
C. To ensure that the loan interest rate fluctuates
D. To incrementally reduce the outstanding principal over time
Scheduled amortization refers to the process where the outstanding principal of the loan is gradually reduced over time through equal monthly payments.
14. What is the key feature of a fully amortized mortgage loan?
A. The loan is paid off early
B. The interest rate changes every year
C. Equal payments are made over the life of the loan
D. Payments are not fixed
A fully amortized mortgage loan requires equal payments over the life of the loan, where each payment is split into interest and principal portions.
15. How are the interest and principal components of a fixed-rate mortgage payment determined?
A. The interest component is based on the beginning-of-period outstanding principal
B. The interest component is based on the remaining principal
C. The interest component is fixed throughout the loan period
D. The principal component is always fixed
The interest component of a fixed-rate mortgage payment is based on the beginning-of-period outstanding principal, while the principal portion increases over time as the loan balance decreases.
16. What is an amortization schedule used for in a fixed-rate mortgage?
A. To calculate the interest rate change
B. To determine the length of the mortgage term
C. To track the principal and interest components of each payment over time
D. To increase the principal repayment at later stages
An amortization schedule helps track the principal and interest components of each payment and how the outstanding principal decreases over time until the loan is fully paid off.
17. What is the mortgage prepayment option for a borrower?
A. A requirement to pay off the mortgage early
B. A penalty for late payments
C. A right to pay off the loan early or pay more than the required monthly payments
D. A fixed schedule for early payments
The mortgage prepayment option allows the borrower to pay off the loan early or make additional payments above the required amount, providing flexibility for loan repayment.
18. Which of the following is NOT a common form of mortgage prepayment?
A. Increasing the frequency or amount of payments
B. Refinancing the outstanding balance
C. Repaying the loan because the property is sold
D. Making only interest payments throughout the loan
Making only interest payments is not a form of mortgage prepayment. Prepayments involve either increasing payment amounts, refinancing, or paying off the loan due to property sale.
19. What generally triggers mortgage prepayments?
A. Borrowers wish to extend the term of the mortgage
B. A fall in market interest rates prompting borrowers to refinance
C. Borrowers default on their payments
D. A rise in property values
Prepayments are more likely when market interest rates fall, as borrowers want to refinance their existing mortgages at a lower rate.
20. How do prepayments affect lenders?
A. Lenders stop receiving high-interest income and must reinvest proceeds at lower rates
B. Lenders gain more interest income because borrowers are paying faster
C. Lenders benefit because the loan term is reduced
D. Lenders charge a fee for early repayment
For lenders, prepayments result in a loss because they stop receiving the high-interest income and are forced to reinvest at lower prevailing market rates.
21. What is the impact of prepayments on agency mortgage-backed securities (MBSs)?
A. Investors gain interest income from prepayments
B. Prepayments have no impact on investors
C. Prepayments and defaults have the same impact on investors
D. Prepayments increase the risk for investors
Prepayments and defaults both impact investors in the same way in agency MBSs, as both result in the return of cash to the investor.
22. What does the weighted average coupon (WAC) of a mortgage pool represent?
A. The sum of the interest rates of all mortgages in the pool
B. The average mortgage rate of the most recent mortgages
C. The weighted average of the mortgage rates in the pool, considering the outstanding balance of each mortgage
D. The interest rate on the MBS issued by the SPV
The weighted average coupon (WAC) is the weighted average of the mortgage rates in the pool, considering the outstanding balance of each mortgage in the pool.
23. What does the weighted average maturity (WAM) of a mortgage pool indicate?
A. The total time it takes to repay all mortgages in the pool
B. The weighted average of all mortgage ages in the pool, weighted by the relative outstanding mortgage balance
C. The length of time the mortgages were originated
D. The expected duration of the MBS
The weighted average maturity (WAM) is the weighted average of all mortgage ages in the pool, weighted by the relative outstanding mortgage balance.
24. What is the significance of the prepayment risk in mortgage-backed securities (MBS)?
A. Prepayment risk affects the investor’s returns because the mortgages may be paid off earlier than expected
B. Prepayment risk leads to higher returns for investors
C. Prepayment risk only affects the original mortgage lender, not MBS investors
D. Prepayment risk makes the MBS less diversified
Prepayment risk in MBS affects the investor’s returns because mortgages may be paid off early, which can result in receiving cash sooner and potentially reinvesting at lower rates.
25. Which of the following best describes the Single Monthly Mortality (SMM) rate for a mortgage pool?
A. The percentage of the mortgage pool's principal that is paid off in a month
B. The percentage of mortgages that default each month
C. The percentage of the remaining principal in the mortgage pool that is paid off due to prepayments each month
D. The percentage of loans that are refinanced each month
The Single Monthly Mortality (SMM) rate refers to the percentage of the remaining principal in the mortgage pool that is paid off due to prepayments each month.
26. How is the Conditional Prepayment Rate (CPR) calculated for a mortgage pool?
A. By dividing the total number of defaulted mortgages by the total number of mortgages in the pool
B. By calculating the percentage of the principal in the pool that is expected to be paid off early due to prepayments over a year
C. By averaging the SMM rates over a year
D. By using the weighted average of all loan interest rates in the pool
The Conditional Prepayment Rate (CPR) is calculated by determining the percentage of the principal in the mortgage pool that is expected to be paid off early due to prepayments over the course of one year.
27. What does the Conditional Prepayment Rate (CPR) represent in the context of mortgage-backed securities (MBS)?
A. The rate at which mortgages default in a pool
B. The rate at which the interest payments on a mortgage are made
C. The annual rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool
D. The monthly rate at which the principal of a mortgage pool is repaid
The Conditional Prepayment Rate (CPR) represents the annual rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool, based on past prepayment rates and economic conditions.
28. How is the Single Monthly Mortality (SMM) rate calculated from the Conditional Prepayment Rate (CPR)?
A. SMM = 1 − (1 − CPR)^(1/12)
B. SMM = (CPR)^(1/12)
C. SMM = 1 − (1 − CPR)^(12)
D. SMM = CPR / 12
The Single Monthly Mortality (SMM) rate is calculated using the formula: SMM = 1 − (1 − CPR)^(1/12), where CPR is the annual prepayment rate.
29. What does a 100% PSA benchmark represent for mortgage pools?
A. The CPR is constant over the life of the mortgage
B. The CPR starts high and decreases over time
C. The CPR increases gradually over time, starting from 0.2% and reaching 6% after 30 months
D. The CPR is lower than the CPR of 50% PSA
A 100% PSA benchmark assumes that the CPR increases gradually over time, starting from 0.2% per month and gradually reaching 6% after 30 months, remaining at that level until the end of the pool’s life.
30. If a mortgage pool exhibits a 50% PSA, what does that mean in terms of prepayment rates?
A. The prepayment rates are half of those prescribed by the 100% PSA benchmark
B. The prepayment rates are twice the rate prescribed by the 100% PSA benchmark
C. The prepayment rates follow the exact rates of the 100% PSA benchmark
D. The prepayment rates are constant throughout the pool's life
A 50% PSA refers to half of the CPR prescribed by the 100% PSA benchmark, meaning the prepayment rates are lower than the standard PSA rates.
31. What does a 200% PSA refer to in terms of prepayment rates?
A. The prepayment rates are half of those prescribed by the 100% PSA benchmark
B. The prepayment rates follow the exact rates of the 100% PSA benchmark
C. The prepayment rates are double the CPR prescribed by the 100% PSA benchmark
D. The prepayment rates are constant throughout the pool's life
A 200% PSA refers to double the CPR prescribed by the 100% PSA benchmark, meaning the prepayment rates are higher than the standard PSA rates.
32. In the specified pools market, how are the pools identified prior to a trade?
A. The pools are randomly assigned to buyers and sellers
B. The buyer has to choose the pool and its characteristics after the trade
C. The seller must provide a pool for every transaction without any specification
D. The number and balances of the pools are identified before the trade
In the specified pools market, the pools are identified before a trade based on their characteristics such as loan balances, coupon rate, and maturity. These characteristics influence the price of the trade.
33. What is the primary risk associated with pass-through agency MBS?
A. Interest rate risk
B. Currency risk
C. Prepayment risk
D. Default risk
The primary risk associated with pass-through agency MBS is prepayment risk, as the timing of cash flows can be uncertain due to mortgage holders paying off their loans early.
34. What does the To Be Announced (TBA) market involve?
A. Identifying the exact pool before the trade is finalized
B. Identifying the security and establishing the price in a forward market, with pools not revealed until two days before settlement
C. The seller choosing the pool after the trade is completed
D. A market where buyers can select mortgage pools from any originator
In the To Be Announced (TBA) market, the security and price are established in a forward market, but the actual pool is not revealed until two days before settlement. This makes it a more liquid market.
35. In a TBA trade, what does the seller need to provide?
A. Mortgages from any pool that meets the established criteria (e.g., coupon rate, par value)
B. Only mortgages from the specified pool for the trade
C. Mortgages with a fixed maturity date
D. Mortgages from pools with specific loan characteristics defined by the buyer
In a TBA trade, the seller needs to provide mortgages from any pool that meets the established criteria, such as the coupon rate and par value, even though the exact pool is not revealed until closer to settlement.
36. What is a key feature of the TBA market that makes it more liquid compared to the specified pools market?
A. It allows the buyer to specify the pool before the trade
B. The seller and buyer are not required to disclose the coupon rate
C. The buyer can trade pools with various characteristics without revealing them
D. The actual pools are not revealed until two days before settlement
The TBA market is more liquid because the actual pools are not revealed until two days before settlement. This provides flexibility for trading and avoids the need for detailed identification of pools in advance.
37. In a dollar roll transaction, what is the key difference between this and a repurchase agreement?
A. The securities bought in the next month must be identical to those sold in the first month
B. There is an interest added onto the repurchase price in the second month
C. The securities bought in the next month may or may not be the same as those sold in the first month
D. There is no loss of interest for the initiating trader
The key difference between a dollar roll transaction and a repurchase agreement is that the securities bought in the next month may or may not be the same as those sold in the first month, unlike in a repurchase agreement.
38. Which of the following is a component of valuing a dollar roll transaction?
A. Price of the pool sold in month 1 without accrued interest
B. Only the price of the pool bought in month 2
C. Coupon and principal payment made on the pool bought in month 2
D. Price at which the pool is sold in month 1, with accrued interest
The components of valuing a dollar roll transaction include the price at which the pool is sold in month 1, with accrued interest. This price is part of the formula to value the dollar roll.
39. What is subtracted in the formula for valuing a dollar roll transaction?
A. Price at which the pool is bought in month 1
B. Interest earned from the sale in the second month
C. Coupon and principal payment that was foregone on the pool sold in month 1
D. Price at which the pool is sold in month 2
The coupon and principal payment that was foregone on the pool sold in month 1 is subtracted in the formula for valuing a dollar roll transaction, as it represents the opportunity cost of the transaction.
40. What is added in the formula for valuing a dollar roll transaction?
A. Coupon payment received from the pool sold in month 1
B. Interest earned on funds from the sale for one month
C. Price at which the pool is bought in month 1
D. Coupon and principal payments made on the pool bought in month 2
The interest earned on funds from the sale for one month is added in the formula for valuing a dollar roll transaction, as it represents the return on the sale proceeds held during the roll period.
41. What are Collateralized Mortgage Obligations (CMOs)?
A. Securities secured by other securities with different risk profiles
B. Bonds with a fixed interest rate and maturity date
C. Securities issued against pass-through securities with cash flows reallocated to different bond classes
D. Bonds that focus only on minimizing prepayment risk
CMOs are securities issued against pass-through securities where the cash flows are reallocated to different tranches. Each tranche has a different risk profile and is tailored to meet varying investor needs, specifically managing contraction and extension risk.
42. What type of risk do Collateralized Mortgage Obligations (CMOs) address?
A. Market risk
B. Interest rate risk
C. Credit risk
D. Prepayment risk (both extension and contraction risk)
CMOs are designed to manage prepayment risk, which consists of extension risk (longer expected life due to rising interest rates) and contraction risk (shorter expected life due to falling interest rates).
43. Which of the following is true about the tranches of a Collateralized Mortgage Obligation (CMO)?
A. All tranches have the same exposure to contraction and extension risk
B. Each tranche represents a different mixture of contraction and extension risk
C. Tranches are identical in terms of risk exposure and cash flow distribution
D. Tranches are designed to minimize all forms of risk exposure equally
Each tranche in a CMO has a different mixture of contraction and extension risk, allowing institutional investors to tailor investments based on specific risk preferences.
44. Who are the primary investors in Collateralized Mortgage Obligations (CMOs)?
A. Retail investors seeking low-risk investments
B. Individuals looking for high-yield short-term bonds
C. Institutional investors and investment managers
D. Government entities focused on economic development
CMOs are typically structured to meet the specific needs of institutional investors and investment managers who have unique asset/liability requirements and are looking to manage different types of prepayment risk.
45. What is the main advantage of Collateralized Mortgage Obligations (CMOs) over standard pass-through securities?
A. CMOs provide a way to redistribute the cash flows from a mortgage pool into different risk packages
B. CMOs offer higher yields compared to other securities
C. CMOs are not exposed to interest rate changes
D. CMOs guarantee higher returns irrespective of market conditions
CMOs allow the cash flows from a mortgage pool to be redistributed into different tranches, each with its own risk profile, giving institutional investors a tailored approach to managing prepayment risks.
46. What is the main characteristic of a Planned Amortization Class (PAC) tranche?
A. It is not affected by prepayment risk
B. It is amortized based on a fixed maturity schedule
C. It is amortized based on a sinking fund schedule within a range of prepayment speeds
D. It has a variable interest rate
A PAC tranche is structured to be amortized based on a sinking fund schedule, which is established within a range of prepayment speeds called the initial PAC collar.
47. What is the role of the support tranche in a PAC structure?
A. To guarantee a fixed return to PAC holders
B. To absorb excess principal payments when prepayment speeds are faster than expected
C. To provide higher yields for investors
D. To provide prepayment protection for the PAC tranches
The support tranche absorbs the excess principal payments when prepayment speeds are faster than the upper repayment rate, providing prepayment protection for the PAC tranche.
48. What happens when prepayment speeds are slower than expected for a PAC tranche?
A. The PAC tranche receives principal according to the PAC schedule, and the support tranche absorbs the excess
B. The PAC tranche receives all payments and the support tranche is paid off
C. The support tranche is paid off first
D. The PAC tranche is deferred, and the support tranche is prioritized
When prepayment speeds are slower than expected, the PAC tranche receives principal according to the PAC schedule, and the support tranche absorbs the excess to maintain the PAC schedule.
49. What occurs when the support tranche in a PAC structure is paid off?
A. The PAC tranche becomes a broken PAC and absorbs all subsequent prepayments
B. The PAC becomes a broken PAC and further prepayments go directly to the PAC tranche
C. The support tranche is no longer required in the structure
D. The PAC structure is dissolved
When the support tranche is paid off, the PAC becomes a broken PAC, and any further prepayments go directly to the PAC tranche, essentially turning it into an ordinary sequential-pay structure.
50. What is the relationship between the prepayment risk of PAC tranches and support tranches?
A. Both have equal prepayment risk exposure
B. PAC tranches have more prepayment risk than support tranches
C. There is an inverse relationship between the prepayment risk of PAC and support tranches
D. PAC tranches have no prepayment risk, while support tranches are highly exposed
There is an inverse relationship between the prepayment risk of PAC tranches and support tranches. As the prepayment risk protection for a PAC tranche increases, the prepayment risk for the support tranche increases.
51. What is the main characteristic of Principal-Only (PO) securities?
A. They receive only the interest portion of each mortgage payment
B. They receive both principal and interest portions of each mortgage payment
C. They receive only the principal portion of each mortgage payment
D. They receive no cash flows from mortgage payments
PO securities receive only the principal portion of each mortgage payment, and the cash flow stream starts small and increases over time as the principal component grows.
52. What happens to the yield of PO securities when prepayment rates increase?
A. The yield increases as principal is returned faster than expected
B. The yield decreases because prepayments are slower
C. The yield remains unaffected by prepayment rates
D. The yield decreases as principal is returned slower than expected
PO securities' yield increases when prepayment rates rise, as the principal is returned faster than expected, leading to a higher yield.
53. How does a decline in interest rates affect the price of PO securities?
A. PO prices decrease as the mortgage pool is paid off sooner
B. PO prices remain the same regardless of interest rates
C. PO prices increase as interest rates fall due to faster principal payments
D. PO prices decrease as interest rates fall due to slower principal payments
When interest rates fall, prepayment rates increase, which leads to a faster return of principal for PO securities, thus increasing their prices.
54. What is the main risk associated with Interest-Only (IO) securities?
A. IO securities may have no risk if prepayment rates are high
B. IO securities may produce less interest than initially expected if prepayment rates are high
C. IO securities are immune to interest rate changes
D. IO securities become more valuable when prepayment rates increase
The main risk with IO securities is that they produce less interest income than expected if prepayment rates are high, as the mortgage pool is paid off sooner.
55. What happens to the value of IO securities when market interest rates fall?
A. IO securities increase in value as the interest payments grow
B. IO securities remain unaffected by changes in interest rates
C. IO securities decrease in value as the mortgage pool is paid off faster
D. IO securities increase in value as prepayment rates decrease
When market interest rates fall, the mortgage pool is paid off sooner, leaving IO investors with no further interest payments, causing IO securities' value to decrease.
56. What is the main purpose of prepayment modeling in mortgage analysis?
A. To forecast the home equity value
B. To predict early repayment of mortgages by borrowers
C. To assess inflation in the housing market
D. To determine credit score of borrowers
Prepayment modeling helps forecast when and why borrowers may repay their mortgages early, affecting the expected cash flows of mortgage-backed securities.
57. Which of the following is not a component of prepayment modeling?
A. Refinancing
B. Turnover
C. Inflation Indexing
D. Defaults
The four key components of prepayment modeling are refinancing, turnover, defaults, and curtailments. Inflation indexing is unrelated to prepayment.
58. What does "turnover" refer to in the context of prepayment modeling?
A. Sale or destruction of the property causing mortgage closure
B. Defaulting of the borrower
C. Government-mandated foreclosure
D. Decrease in mortgage rates
Turnover in prepayment refers to mortgage prepayments resulting from the sale or destruction of the property, typically when borrowers move or sell.
59. What triggers a mortgage prepayment due to defaults?
A. Borrower chooses to pay more
B. Property value increase
C. Reduced loan tenure
D. Lender sells the property to recover loan
If a borrower defaults, the lender may recover funds by selling the property, resulting in mortgage prepayment from the proceeds.
60. What are curtailments in the context of mortgage prepayment?
A. Full payment of remaining mortgage
B. Mortgage default
C. Partial prepayment using excess cash
D. Delay in payment
Curtailments are partial prepayments made by borrowers to reduce their outstanding mortgage balance before due time.
61. What is cash-out refinancing?
A. Taking a new mortgage to repay the old one and gain extra cash
B. Selling a house to recover cash
C. Paying off a loan in cash
D. Withdrawing money from an ATM
Cash-out refinancing involves taking a larger mortgage than the current balance, using the extra amount for personal use while repaying the old loan.
62. What is typically used in models to forecast refinancing behavior?
A. Insurance premium ratios
B. Incentive functions based on mortgage rate structures
C. Household size and composition
D. Amount of rent paid
Incentive functions using current and past mortgage rate structures help model the likelihood of refinancing due to expected savings.
63. Which of the following can also influence refinancing besides interest rate decline?
A. Size of the house
B. Number of dependents
C. Age of the borrower
D. Improved credit rating of the borrower
Even if rates remain constant, borrowers may refinance if their credit rating improves and they qualify for lower interest rates.
64. What happens to prepayment activity when interest rates fall and WAC − R becomes positive?
A. Prepayment activity increases
B. Prepayment activity remains unchanged
C. Prepayment activity stops
D. Prepayment activity decreases
As interest rates fall and WAC − R becomes positive, refinancing becomes attractive, leading to increased prepayment activity.
65. What is the term for reduced prepayment activity after homeowners have already refinanced once?
A. Refinance lag
B. Burnout
C. Rate insensitivity
D. Liquidity trap
Burnout refers to the phenomenon where homeowners who could refinance have already done so, reducing prepayment activity during subsequent rate drops.
66. Which factor does not directly influence housing turnover according to the passage?
A. Age of the mortgagees
B. Seasonality
C. Historical mortgage rates path
D. Location of the property
The path of mortgage rates does not directly impact housing turnover, as most borrowers sell their homes irrespective of rate changes.
67. What is the 'lock-in effect' in the context of mortgage turnover?
A. When homeowners refinance to avoid rate changes
B. When lenders restrict prepayments
C. When default risk is reduced by higher payments
D. When borrowers delay selling to avoid higher new mortgage costs
The lock-in effect refers to the tendency of borrowers to avoid moving or refinancing due to the higher cost of a new mortgage.
68. What factor is generally not included in prepayment models due to default?
A. Seasonality
B. FICO scores
C. Loan-to-value ratios
D. Housing market conditions
While LTV, FICO scores, and market conditions are critical for default modeling, seasonality is not typically relevant in that context.
69. Curtailments are best described as:
A. Prepayments made when the mortgage is new
B. Full repayments upon property sale
C. Partial payments made by borrowers
D. Missed payments due to default
Curtailments are partial prepayments usually occurring in older or low-balance mortgages, reducing the principal earlier than scheduled.
70. Why is Monte Carlo simulation used to value MBS instead of traditional option valuation methods?
A. Because it is faster than other methods
B. Because it is better for pricing stocks
C. Because it only requires historical interest rates
D. Because MBS has path-dependent prepayment options
Monte Carlo simulation is used because MBS valuation involves path-dependent prepayment behavior, which traditional option models can't handle well.
71. What type of path dependence affects prepayments in MBS?
A. Interest rate paths and housing price movements
B. Loan origination documents
C. Federal Reserve policies
D. Credit score fluctuations
Prepayments depend on interest rate paths (e.g., prior refinance opportunities) and housing price movements (which affect default and cash-out refinance behavior).
72. What is the term used to describe the slowing down of prepayments after an extended period of falling interest rates?
A. Repricing delay
B. Mortgage drag
C. Refinancing burnout
D. Amortization freeze
Refinancing burnout occurs when many homeowners have already refinanced early in a rate-decline cycle, reducing further prepayments.
73. Which scenario is most likely to increase prepayment activity due to housing price movements?
A. A decline in housing prices
B. A significant rise in housing prices
C. A stable housing market
D. An increase in property taxes
Significant increases in home values often lead to cash-out refinancing, which contributes to higher prepayment rates.
74. Which of the following is an advantage of Monte Carlo simulation for MBS valuation?
A. Requires no modeling assumptions
B. Avoids use of interest rate models
C. Can handle complex path dependencies
D. Focuses only on average cash flows
Monte Carlo simulation is effective at modeling scenarios with path-dependent behaviors, such as interest rate and housing price effects on prepayments.
75. Which characteristic of a mortgage pool is associated with higher prepayment rates?
A. Lower average mortgage size
B. Larger average mortgage size
C. Lower loan-to-value ratio
D. Higher FICO scores
Larger average mortgage sizes are linked with greater financial incentive to refinance, hence a higher prepayment rate.
76. What combination increases the likelihood of defaults in a mortgage pool?
A. High FICO score and low LTV ratio
B. High income and large mortgage size
C. Low FICO score and high loan-to-value ratio
D. Low LTV ratio and stable income
Borrowers with low credit scores and high loan-to-value ratios are more likely to default on their loans.
77. What does the Monte Carlo simulation provide in the context of MBS valuation?
A. A deterministic single value
B. A fixed coupon payment schedule
C. A binomial distribution of returns
D. A probability distribution of possible MBS values
Monte Carlo simulation produces a range of possible values for the MBS, forming a probability distribution.
78. What is considered the estimated value of an MBS in Monte Carlo simulation?
A. The mean of all simulated present values
B. The maximum of all outcomes
C. The lowest possible present value
D. The value from the first simulation run
The average of the present values from all simulations is taken as the estimated value of the MBS.
79. Which of the following is the correct first step in valuing an MBS using Monte Carlo simulation?
A. Determine prepayment rates
B. Simulate risk-free rates and housing prices
C. Compute present value of cash flows
D. Average all the simulation outcomes
Step 1 in Monte Carlo simulation is to simulate the path of risk-free interest rates and housing prices.
80. What is the final step in valuing an MBS using Monte Carlo simulation?
A. Project monthly cash flows
B. Determine prepayment rates
C. Compute the average value of all simulated present values
D. Simulate another interest rate path
After repeating the simulation process many times, the final step is to compute the average of all the simulated present values to estimate the MBS value.
81. What does Option-Adjusted Spread (OAS) measure in the context of MBS?
A. Difference between mortgage rate and LIBOR
B. Yield of MBS ignoring prepayment risk
C. Return on risk-free Treasuries
D. Excess return on MBS adjusted for prepayment risk
OAS reflects the compensation an investor receives from an MBS after accounting for the borrower's option to prepay.
82. Why is the spread referred to as “option-adjusted” in OAS?
A. Because the MBS cash flows account for prepayment options
B. Because it's adjusted for market options pricing
C. Because it removes all default risks
D. Because it ignores reinvestment risk
The term "option-adjusted" means the spread considers the effect of borrowers’ ability to prepay their mortgages, which is an embedded option in MBS.
83. What is the first step in determining the Option-Adjusted Spread (OAS)?
A. Perform a Monte Carlo simulation
B. Make a preliminary OAS estimate
C. Compare simulated and market prices
D. Adjust OAS to match the simulated price
The OAS valuation process starts with making an initial estimate of the spread to be used in simulations.
84. What happens if the market price of an MBS is higher than the simulated price using the current OAS estimate?
A. Increase the OAS estimate
B. Leave the OAS estimate unchanged
C. Decrease the OAS estimate
D. Use a higher Treasury rate instead
A higher market price means the current discounting is too aggressive, so the OAS estimate must be lowered to bring the simulated price up.
85. What is the objective of the iterative process in OAS calculation?
A. To match the simulated price with the market price
B. To maximize the MBS return
C. To find the lowest possible spread
D. To minimize the Treasury rate impact
The goal of the iterative process is to adjust the OAS so that the present value of simulated cash flows equals the observed market price.
86. How is the Option-Adjusted Spread (OAS) defined?
A. Spread between the current Treasury rate and MBS rate
B. Spread between mortgage rates and LIBOR rates
C. Spread that adjusts for default risk in MBS
D. Spread added to spot rates to make the average present value of paths equal to the market price
The OAS is the spread that, when added to the spot rates of interest paths, makes the average present value of the paths equal to the market price.
87. What does a higher OAS indicate in terms of investment preference?
A. A higher return over Treasuries
B. Lower prepayment risk
C. Higher default risk
D. More uncertainty in market price
A higher OAS means greater compensation over Treasuries, making the MBS more attractive to investors.
88. What is a major challenge in using OAS valuation estimates generated from Monte Carlo simulation?
A. Inaccurate modeling of interest rates
B. Inability to account for defaults
C. Dependence on the prepayment model
D. Inability to simulate multiple scenarios
The greatest weakness is the reliance on the prepayment model, which is complex and subject to significant uncertainty.
89. What is the primary risk when using Monte Carlo methods to value MBS using OAS?
A. Modeling error in adjusting interest rate paths
B. Incorrect prepayment assumptions
C. Lack of consideration for market volatility
D. Misvaluation of Treasury futures
A primary risk is the error introduced while adjusting interest rate paths to reflect the accurate valuation of securities.
90. Why might there not be a perfect hedge using Treasury futures when employing OAS?
A. Because Treasury futures do not account for mortgage prepayment behavior
B. Because the correlation between mortgage rates and Treasury rates is imperfect
C. Because Treasury rates fluctuate more than mortgage rates
D. Because OAS calculations ignore risk-free rates
A perfect hedge is not possible because mortgage rates and Treasury rates do not move perfectly in sync.
