Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

For investors in an asset-backed security, when is prepayment risk a significant concern?

1. When interest rates move higher.

2. When interest rates move lower.

3. As the investor will receive principal later than expected.

4. As the investor will receive interest earlier than expected.

The correct answer is: When interest rates move lower.

Prepayment risk becomes a significant concern for investors in asset-backed securities particularly when interest rates decline. In such scenarios, borrowers may take advantage of lower interest rates by refinancing their existing loans at more favorable terms. This can lead to an increase in the rate of prepayments on the underlying loans that back the asset-backed securities. Consequently, investors may receive their principal back earlier than anticipated, which limits their ability to reinvest that capital at the higher original interest rates. When interest rates move lower, it generates an environment conducive to refinancing, thus amplifying prepayment activity. Investors may face the challenge of reinvesting the unexpected return of principal at lower yields, impacting their overall returns. The other scenarios, where interest rates rise, involve different dynamics which generally lead to reduced prepayment activity, making prepayment risk less of a concern in those circumstances.