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

What type of risk might an investor in a mortgage-backed security face due to fluctuations in interest rates?

1. Default risk

2. Reinvestment risk

3. Market risk

4. Liquidity risk

The correct answer is: Reinvestment risk

The correct response is reinvestment risk, which is particularly relevant for investors in mortgage-backed securities because these securities often provide cash flow from the monthly payments made by mortgage holders. When interest rates fall, homeowners may refinance their mortgages to take advantage of lower rates, leading to an increase in prepayments on the underlying loans in the mortgage-backed security. This results in investors receiving their principal back sooner than expected, which they may have to reinvest in a lower interest rate environment. If interest rates drop, the investor could find themselves in a situation where they must reinvest these proceeds at lower yields, thus potentially reducing their overall returns. Therefore, reinvestment risk is a fundamental concern for investors in mortgage-backed securities, centered around the variability in the interest rates and the impact it has on future cash flows.