Final answer:
With the decrease in interest rates, the duration of an MBS would likely decrease due to borrowers increasing prepayment by refinancing their mortgages, which shortens the cash flow period and the duration of the security. The correct option is b. Decrease because borrowers increase prepayment by refinancing their loans.
Step-by-step explanation:
When interest rates decrease, you would expect the duration of a mortgage-backed security (MBS) to change due to changes in borrower behavior. Specifically, the correct answer is b. Decrease because borrowers increase prepayment by refinancing their loans.
Lower interest rates incentivize borrowers to refinance their existing mortgages to take advantage of the lower rates. When borrowers refinance, they typically pay off their old mortgages early, which increases prepayments on the MBS. Prepayments shorten the cash flow period of the MBS, resulting in a decreased duration.
The duration of an MBS indicates how sensitive it is to changes in interest rates and represents the average time it takes for the investor to be repaid through mortgage payments. Increased prepayments because of refinancing will cause the MBS duration to decline since the investor receives their money back quicker than initially anticipated.