Collateralized Mortgage Obligations (CMOs): Prepayment Risk vs. Extension Risk
An investor in a Collateralized Mortgage Obligation (CMO) tranche observes that mortgage interest rates across the national economy have fallen sharply from 7.5% to 4.5%. Which primary risk will this CMO tranche experience?
When interest rates FALL, Prepayment Risk surges: homeowners refinance at lower rates, returning principal early and forcing investors to reinvest in lower-yielding securities.
Complete Analysis & Legal Rationale
Mortgage-backed securities and CMO tranches face two inverse interest rate risks: (1) Prepayment Risk occurs when interest rates FALL. Homeowners refinance their mortgages into cheaper loans, causing mortgage pools to pay off faster than anticipated. The investor's bond matures early, and cash must be reinvested at today's lower prevailing interest rates; (2) Extension Risk occurs when interest rates RISE. Homeowners stay in their homes and do not refinance, extending the bond's expected life and locking the investor into below-market yields.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
When interest rates FALL, Prepayment Risk surges: homeowners refinance at lower rates, returning principal early and forcing investors to reinvest in lower-yielding securities.
Fails to adhere to suitability standards regarding B.
Fails to adhere to suitability standards regarding C.
Fails to adhere to suitability standards regarding D.
Official Standard: Mortgage-backed securities and CMO tranches face two inverse interest rate risks: (1) Prepayment Risk occurs when interest rates FALL. Homeowners refi