Which of the following is the best definition of extension risk? The adverse consequences of: A) lower prepayment rates. B) increasing interest rates on passthrough securities. C) higher prepayment rates. D) declining interest rates on passthrough securities. Your answer: A was incorrect. The correct answer was B) increasing interest rates on passthrough securities. Increasing interest rates will slow prepayments resulting in extending the maturity of the passthrough. This reduces the amount available to be invested at the currently high interest rates. **************************************************************** The question kind of irrates me. When interest rates rise prepayments drop which is the cause of the extension. Anything that caused prepayments to drop would cause extension wouldn’t it? I was set on hitting B immediately, but changed to A because I thought B wouldn’t encompass all the scenarios where extension risk could happen. Legit gripe or not?
You are correct mwvt9, we are indifferent between option A & B. Only B is a much more formal and a structured way of saying "yea, that’s why the extension risk!!” CFAI should have lesser gray options than these.
I was going to go with A as well, but after giving it more thought I can see why B is the better choice. Lower prepayment rates is the mechanism by which extension risk occurs, but it is not the cause of extension risk.
True, but interest rates are not the sole cause of lower prepayments either, which is why I ultimately choose A. I have learned my lesson though.