Which risk is specifically associated with Mortgage Backed Securities due to homeowners refinancing or making early payments?

• A. Prepayment risk
• B. Market risk
• C. Default risk
• D. Inflation risk

Answer: (A)

Prepayment risk is the risk that homeowners will pay down their mortgages earlier than planned, and this is specific to Mortgage Backed Securities because their cash flows come from those underlying loan payments. When borrowers refinance or make extra principal payments, the security returns principal sooner than expected, shortening its actual life and forcing the investor to reinvest the proceeds at current, often lower, rates. This can reduce overall yield and change the security’s duration. The effect is amplified when interest rates fall, as refinancings rise; when rates rise, prepayments slow, increasing exposure to interest-rate risk. Other risks listed—market risk, default risk, and inflation risk—are broader or different in nature and don’t capture the unique impact of borrowers paying off loans early.