How does falling interest rates affect the duration of mortgages?

Falling interest rates typically lead to an increase in mortgage refinancing activity because homeowners find it financially beneficial to secure lower rates. When interest rates drop, the cost of borrowing decreases, prompting many homeowners to prepay their existing higher-rate mortgages and refinance to take advantage of the lower rates. This prepayment contributes to a reduction in the average life of the mortgage, as the loans are paid off sooner than initially anticipated.

This relationship between interest rates and mortgage prepayments is crucial for understanding the concept of duration in the context of fixed income securities. Duration measures the sensitivity of a bond's price to changes in interest rates as well as the time it takes for an investor to receive cash flows. In this scenario, with falling interest rates driving prepayments, the effective duration of mortgages decreases because homeowners are opting to pay off their debts more quickly.

The other choices do not reflect the dynamics at play when interest rates decline. For example, the notion that the average life of the bond increases contradicts the trend observed with prepayments. Similarly, asserting that the duration remains unchanged disregards the impacts of changing interest rates on borrower behavior, while suggesting that mortgages become more difficult to pay off does not align with the incentive created by lower rates for borrowers to manage their