Asset-Backed Securities

Lesson

Asset-backed securities (ABS) are financial instruments backed by a pool of assets, such as mortgages, credit card receivables, or auto loans. These securities are created by pooling the cash flows from the underlying assets and then selling them to investors as bonds. The cash flows generated by the assets are used to pay interest and principal to the bondholders. ABS can provide investors with a steady income stream and diversification in their investment portfolios.

Practice Question #1

Which of the following is NOT an example of an asset-backed security?

A) Mortgage-backed securities

B) Credit card receivables

C) Corporate bonds

D) Auto loans

Select an option above to see an explanation here.

A) Mortgage-backed securities are a type of ABS backed by mortgages. B) Credit card receivables can be pooled to create an ABS. C) Corporate bonds are debt instruments issued by companies, not backed by specific assets. D) Auto loans can be pooled to create an ABS.

Terms

Asset-backed securities (ABS):: Financial instruments backed by a pool of assets, such as mortgages, credit card receivables, or auto loans.
Prepayment risk:: The risk that borrowers will pay off their loans early, reducing the cash flows available to bondholders.
Tranches:: Different classes of bonds within an ABS, each with varying levels of risk and return.
Mortgage-backed securities (MBS):: A type of ABS backed explicitly by mortgages.
Collateralized debt obligations (CDOs):: A type of ABS backed by a diverse pool of debt instruments, such as bonds and loans.

Practice Question #2

What is the primary purpose of diversification in an investment portfolio?

A) To increase returns

B) To reduce risk

C) To ensure liquidity

D) To minimize taxes

Select an option above to see an explanation here.

A) Diversification can help increase returns, but its primary purpose is to reduce risk. B) Diversification reduces risk by spreading investments across different asset classes. C) Liquidity is not directly related to diversification. D) Minimizing taxes is not the primary purpose of diversification.

Do Not Confuse With

Government bonds:: Debt instruments issued by governments, not backed by specific assets.

Practice Question #3

Which of the following risks is associated with investing in asset-backed securities?

A) Inflation risk

B) Prepayment risk

C) Interest rate risk

D) All of the above

Select an option above to see an explanation here.

A) Inflation risk is not specific to ABS. B) Prepayment risk is the risk that borrowers will pay off their loans early, reducing the cash flows available to bondholders. C) Interest rate risk is not specific to ABS. D) Only prepayment risk is specific to ABS.

Historical Example

In the early 2000s, the housing market experienced a boom, leading to an increase in the issuance of mortgage-backed securities. However, when the housing market crashed in 2007-2008, many of these securities defaulted, contributing to the global financial crisis.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

A credit card company pools the monthly payments from thousands of credit card users and creates an asset-backed security. Investors who purchase this security receive interest and principal payments from credit card users.