CFA Practice Question

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CFA Practice Question

Holding other factors constant, the embedded option cost of mortgage pass-through securities is higher if ______

I. the average contract rate is higher.
II. the mortgage pool is older.
III. the prevailing mortgage rate is higher.
Correct Answer: I only

An older mortgage pool or higher prevailing mortgage rate would stimulate prepayments and thus increase the option cost of mortgage pass-through securities.

User Contributed Comments 5

User Comment
americade the higher the contract rate the greater the long put value
just like if the stock index or security is at its highest, a long put is at its highest level.
danlan2 If II and III would stimulate prepayments and increase the option cost, then II and III are right?
Lavay It is the opposite of ii and iii that will stipulate prepayments
rhardin I think II is correct. While older loans will mean less people refinancing, you are more likely to prepay (which is what the question is asking about.) In fact, the PSA benchmark reflects this by ramping up the prepayment over 30 months to show that a 20 month old mortgage has a greater prepayment rate than a 5 month old mortgage.
quanttrader option is more in the money -- likelier to be exercised- ie option to prepay/refinance if the average rate of the contract is higher than current prevailing rates.
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