Canadian Securities Course (CSC) Level 2 Practice Exam

What are some risks associated with Mortgage Backed Securities?

1. Interest rate risk

2. Credit risk

3. Inflation Risk

4. Market risk

The correct answer is: Interest rate risk

Mortgage Backed Securities (MBS) indeed carry various risks, and interest rate risk is a significant concern. This risk arises from the possibility that changes in interest rates can affect the value of the MBS. When interest rates rise, the market value of existing MBS typically declines because newer issues may offer higher returns. Conversely, lower interest rates can increase the attractiveness of existing MBS, but they also encourage homeowners to refinance, which can lead to prepayment risk. This introduces uncertainty for investors regarding the duration of cash flows and can reduce overall returns. While credit risk, inflation risk, and market risk are relevant in other contexts, they are not as closely associated with MBS as interest rate risk. Credit risk pertains to the potential for homeowners to default on their loans, impacting the cash flow to MBS investors. Inflation risk relates to the risk that inflation may erode the purchasing power of the cash flows from the MBS. Market risk refers to the risk of losses due to changes in market prices or values. Each of these risks is important to consider, but interest rate risk is particularly integral to the valuation and performance of Mortgage Backed Securities.