PREPAYMENT RISK AND THE DURATION OF DEFAULT-FREE MORTGAGE-BACKED SECURITIES

The conventional duration measure for mortgage-backed pass-through securities assumes that the prepayment rate is invariant to changes in market interest rates. In this paper, the conventional duration is modified to take into account the interest-rate sensitivity of mortgage prepayments. Including interest rate sensitivity is shown to reduce substantially the duration of a mortgage-backed pass-through security when the current mortgage rate is less than the contract rate.