Future Business Leaders of America (FBLA) Securities and Investments Practice Test

What is prepayment risk associated with?

1. A decrease in property value

2. Mortgages being paid off sooner than expected

3. An increase in interest rates

4. Delays in mortgage approvals

The correct answer is: Mortgages being paid off sooner than expected

Prepayment risk is specifically associated with mortgages being paid off sooner than expected. This risk arises when borrowers refinance or pay off their loans ahead of schedule, often in response to falling interest rates. When this happens, lenders receive their principal back sooner than anticipated and may have to reinvest the funds at lower prevailing interest rates, which can adversely affect their returns. Understanding prepayment risk is crucial for investors in mortgage-backed securities. If a significant number of loans are prepaid, investors may find themselves receiving less than they initially projected in terms of cash flow, as the anticipated duration of their investment shortens. This unpredictability in cash flows can complicate financial planning and diminish overall investment strategies. The other options do not accurately represent prepayment risk. While property values can fluctuate and interest rates can change, these factors do not directly relate to the concept of prepayment risk itself. Delays in mortgage approvals may affect the timing of transactions but are also not relevant to prepayment risk. Thus, the emphasis on mortgages being paid off earlier than expected distinctly defines the nature of prepayment risk.