Final answer:
A conditional prepayment rate (CPR) of 8% indicates that about 8% of the outstanding mortgage pool balance is expected to be prepaid within a year. This prepayment risk affects mortgage-backed securities and can be influenced by rising interest rates, which may lead to higher mortgage payments for homeowners with ARMs.
Step-by-step explanation:
In the context of mortgage-backed securities, a conditional prepayment rate (CPR) of 8% means that approximately 8% of an outstanding mortgage pool balance at the beginning of the year will be prepaid over the course of the next year. Mortgage-backed securities are subject to prepayment risk because homeowners can pay off their mortgages early, and the CPR is used to estimate the rate at which this prepayment will occur. This can be influenced by various factors, such as changes in interest rates, which affect the affordability of mortgage payments. When rates rise significantly, homeowners with adjustable-rate mortgages (ARMs) may face steep increases in their monthly payments. For example, a monthly mortgage payment for a $250,000 home could escalate dramatically as interest rates adjust from an introductory rate to a higher rate.