Question 71

Prepayment risk is the most relevant risk to an investor purchasing mortgage-backed securities instead of common stock.

Prepayment risk refers to the possibility that borrowers will pay off their mortgage loans earlier than expected, which can adversely affect the returns on mortgage-backed securities. This risk is particularly significant for investors in these securities as it can lead to a reduction in expected cash flows.

A) Market risk

Market risk pertains to the potential losses due to changes in market conditions affecting the overall market. While it is relevant to all investments, including both mortgage-backed securities and common stock, it is not the most pertinent risk associated specifically with mortgage-backed securities.

B) Political risk

Political risk involves the uncertainty associated with changes in government policy or political instability that can impact investments. Although it can affect various asset classes, it is less directly related to the nature of mortgage-backed securities compared to prepayment risk.

C) Currency risk

Currency risk concerns the potential for loss due to fluctuations in exchange rates, which primarily affects investments in foreign assets. Since mortgage-backed securities are typically denominated in the domestic currency, this risk is not as relevant for investors in these securities as it is for those investing in common stock in foreign markets.

D) Prepayment risk

Prepayment risk is particularly relevant to mortgage-backed securities, as it directly impacts the timing and amount of cash flows to investors. When borrowers refinance or pay off their mortgages early, it can lead to a return of principal sooner than anticipated, thus reducing overall returns.

Conclusion

Prepayment risk is the most relevant concern for investors in mortgage-backed securities because it specifically affects the cash flow patterns associated with these investments. Other risks such as market, political, and currency risks are less directly tied to the nature of mortgage-backed securities, making them less critical in this context. Understanding prepayment risk is essential for accurately assessing the investment's potential performance.