A portfolio manager is evaluating investments in mortgage securities as part of a portfolio to fund long term liabilities. If she wants to minimize prepayment risk in her portfolio she is most likely to invest in:
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A. B. C. D.C
The correct answer is option C, Collateralized Mortgage Obligations (CMOs).
Prepayment risk is the risk that borrowers will repay their mortgages earlier than expected, which can affect the cash flows and yields of mortgage-backed securities. Therefore, to minimize prepayment risk, the portfolio manager would want to invest in securities that have a more predictable cash flow profile.
Mortgage loans (option A) have a high level of prepayment risk since borrowers can pay off their mortgages at any time without penalty. Therefore, they are not an effective option for minimizing prepayment risk.
Mortgage pass-through securities (option B) are also subject to prepayment risk, as homeowners can refinance their mortgages or sell their homes, which can cause early repayment of the underlying mortgages. While the cash flows of pass-through securities are less predictable than those of mortgage loans, they are more predictable than other types of mortgage securities, making them a viable option for certain investors.
Collateralized Mortgage Obligations (CMOs) (option C) are mortgage-backed securities that are structured to have different classes, or tranches, with varying maturities and prepayment risk. The tranches are created by dividing the cash flows from the underlying mortgage pool into different groups based on priority of payment. The highest priority tranches are paid first, while the lower priority tranches are paid later, and are thus subject to higher prepayment risk. By selecting the appropriate tranche, the portfolio manager can minimize the prepayment risk in the portfolio.
Option D, Investment evaluation, is not a type of mortgage security and does not directly address prepayment risk, and is therefore not the correct answer.