Mortgage-backed securities (MBS) are a class of securities where the underlying is a pool of mortgages. Assume that the mortgages are insured, so that they do not have default risk. The mortgages have prepayment risk because the borrower has the option to repay the loan early (at any time) usually due to favorable interest rate changes. From an investor’s point of view, a mortgage-backed security is equivalent to holding a long position in a non-prepayable mortgage pool and which of the following?
A. A long American call option on the underlying pool of mortgages.
B. A short American call option on the underlying pool of mortgages.
C. A short European put option on the underlying pool of mortgages.
D. A long American put option on the underlying pool of mortgages.
Answer:B
Prepayment risk is equivalent to an American call option because the borrower can repay at any time and the position is short because the option lies with the borrower.
 
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