Question

Which of the following statements best reflects the importance of an assumed prepayment speed in regard to managing the cash flows of a pass-through security?

A) The assumed prepayment speed has no impact on managing the cash flows of a pass-through security.

B) Accurate estimation of prepayment speed is crucial for effectively managing the cash flows of a pass-through security.

C) The assumed prepayment speed is relevant only for government-backed pass-through securities.

D) Managing cash flows for a pass-through security is independent of the assumed prepayment speed.

Answer 1

The assumed prepayment speed significantly impacts the management of cash flows for pass-through securities because it influences the timing and the amount of cash flows, thus affecting the yield and duration of the security. B)Accurate estimation of prepayment speed is critical for effective cash flow management.

Step-by-step explanation:

The question pertains to the management of cash flows in pass-through securities, which are financial instruments that aggregate the cash flows from a pool of underlying assets, such as mortgages, and pass them on to investors. The assumed prepayment speed, which is the rate at which borrowers are expected to pay off their loans earlier than scheduled, is a critical factor in estimating the cash flows from these securities. If borrowers prepay their mortgages faster or slower than anticipated, it changes the timing and the amount of cash flows, affecting the yield and the duration of the security.

Therefore, the correct answer is B: Accurate estimation of prepayment speed is crucial for effectively managing the cash flows of a pass-through security. An incorrect assumption about prepayment speed can lead to mispricing of the security and misaligned investment strategies.