Series 7 - General Securities Representative Exam

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Which one of the following is a risk of investing in CMOs when interest rates are falling?

The probability of default can increase; leaving a CMO holder vulnerable to future defaults
A
There may be less of a market for future investment in CMOs
B
Refinancing activity may result in prepayments that adversely affect CMO holders
C
If rates fall enough, CDOs will be more attractive than CMOs and liquidity risk may increase
D

Explanations

Refinancing activity may result in prepayments that adversely affect CMO holders. When homeowners refinance their mortgage, the CMO tranche will experience large increase in payoffs. The return to the investor may be less than originally anticipated because of this. This is the prepayment risk of the CMO

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