CFA Practice Question
Select the correct statement(s).
II. Contraction risk refers to the decrease in the interest rate sensitivity of mortgage pass-through securities.
I. Extension risk is the risk that as interest rates rise, prepayments will slow.
II. Contraction risk refers to the decrease in the interest rate sensitivity of mortgage pass-through securities.
Correct Answer: I and II
User Contributed Comments 9
| User | Comment |
|---|---|
| danlan2 | Is II correct? |
| ianrh | I think 2 is incorrect. Contraction risk is if prepayments increase (from lower interest rates). |
| jangro | I do believe it is correct since cashflows speed up=>duration is shorter=>sensitivity drops...or am I wrong? |
| valeris | Agree, II is right - price of the bond doesn't go up as much due to prepayments. |
| Lavay | Duration is the sensitivity of a bond's price to interest rates. During contraction duration drops, which means the sensitivity of the bond's price as interest rates drops also drops. II is correct. |
| alki | The reason for the duration to drop during contraction is the additional payments that come in which lowers the maturity of the security, lower the maturity, the lower will be its duration.... |
| Luke41 | average life approximates duration, so as avg life decreases, so will duration |
| actiger | II is correct. |
| mazen1967 | during contraction duration drops ; it is the sensetivity of the bond prices to intrest rate |