A mortgage-backed security has been divided into three classes or tranches as follows:
- Tranche I receives net interest and all the principal payments until it is completely paid off.
- Tranche II receives its share of net interest and starts receiving all the principal repayments after Tranche I has been completely paid off. Prior to that, it only receives interest payments.
- Tranche III receives monthly net interest and starts receiving all principal repayments after Tranches I and II have been completely paid off. Prior to that, it only receives interest payments.
For a relatively small decline in mortgage interest rates, which of the tranches has the least amount of prepayment risk?
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A) |
Prepayment risk is equal for all three tranches. | |
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Tranche III has the least amount of prepayment risk since it receives the prepayments last.
For an investor who is interested in long-term gains, in which tranche should s/he invest?
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C) |
Any of the tranches since mortgage-backed securities generally have a long duration. | |
Tranche III has the least amount of prepayment risk; therefore, there is a greater chance that the investor will be able to hold on to the investment for a longer time horizon.
