Canadian Securities Course (CSC) Level 2 Practice Exam

Which risk factor increases with maturity of Mortgage Backed Securities?

1. Market risk

2. Credit risk

3. Interest rate risk

4. Liquidity risk

The correct answer is: Interest rate risk

The correct answer is indeed interest rate risk. As the maturity of Mortgage Backed Securities (MBS) increases, the sensitivity of the security's price to changes in interest rates also increases. This is because longer-term securities have cash flows that are further in the future, making them more vulnerable to fluctuations in interest rates. If interest rates rise, the present value of these future cash flows decreases, leading to a decline in the price of the security. Market risk, while relevant, does not necessarily increase with maturity in the same direct correlation that interest rate risk does. Credit risk refers to the possibility of the borrower defaulting, which is more related to the creditworthiness of the underlying mortgages rather than the maturity of the MBS itself. Liquidity risk pertains to how easily an asset can be bought or sold in the market without affecting its price; while this can be a concern for MBS, it doesn't specifically increase with maturity in a consistent manner like interest rate risk does.