What risk is unique to holders of mortgage backed pass through securities?
Prepayment Risk
Mortgage-backed pass-through securities are financial instruments that represent ownership in a pool of residential mortgages. The holders of these securities bear several unique risks, including prepayment risk and interest rate risk. However, the most significant risk that is unique to holders of mortgage-backed pass-through securities is prepayment risk.
Prepayment risk refers to the possibility that mortgage borrowers will pay off their loans early, resulting in an abrupt return of principal to the pass-through security holder. When interest rates decline, homeowners often refinance their mortgages to take advantage of the lower rates. This causes the mortgage-backed securities to prepay faster than anticipated, which can result in the investor receiving their principal back earlier than expected.
In this scenario, the investor is forced to reinvest the principal at a lower interest rate, resulting in lower overall returns than initially anticipated. Prepayments can also affect the yield and duration of the securities, which can make it more challenging for investors to accurately forecast expected returns.
In summary, the unique risk associated with holding mortgage-backed pass-through securities is prepayment risk.
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