SIE (Securities Industry Essentials) Practice Exam

One of the primary risks associated with mortgage-backed securities is:

1. Credit risk

2. Prepayment risk

3. Interest rate risk

4. Currency risk

The correct answer is: Prepayment risk

Mortgage-backed securities (MBS) are investments that are backed by mortgages. In this case, when someone takes out a mortgage to purchase a property, the lender can either sell that mortgage to another financial institution or bundle it with other mortgages into an MBS and sell it to investors. As a result, investors receive a share of the payments made by homeowners on their mortgages. While there are multiple risks associated with MBS, one of the primary risks is prepayment risk. This means that the homeowners can choose to pay off their mortgage earlier than expected, which can negatively impact the return to investors. If interest rates decrease and homeowners refinance their mortgages, investors lose out on the higher interest rate payments. Likewise, if homeowners make extra payments, investors receive their principal back earlier than expected. The other options listed in the question are not the primary risks associated with MBS. Credit risk refers to the risk of the borrower defaulting on their mortgage, which can be mitigated by diversifying the mortgages within an MBS. Interest rate risk refers to the risk of changes in interest rates affecting the value of an investment, but this is not specific to MBS as it applies to all fixed-income investments. Currency risk only applies