LOS f: State the motivation for creating a collateralized mortgage obligation.

Q1. 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?

A)   Prepayment risk is equal for all three tranches.

B)   Tranche III.

C)   Tranche I.

Q2. For an investor who is interested in long-term gains, in which tranche should s/he invest?

A)   Tranche I.

B)   Any of the tranches since mortgage-backed securities generally have a long duration.

C)   Tranche III.

Q3. Which of the following statements about creating a collateralized mortgage obligation (CMO) is FALSE? A CMO:

A)   redistributes the risk between the tranches on an unequal basis.

B)   does not affect the overall risk of prepayment.

C)   redistributes the risk between the tranches on a random basis.

LOS f: State the motivation for creating a collateralized mortgage obligation.fficeffice" />

Q1. 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?

A)   Prepayment risk is equal for all three tranches.

B)   Tranche III.

C)   Tranche I.

Correct answer is B)

Tranche III has the least amount of prepayment risk since it receives the prepayments last.

Q2. For an investor who is interested in long-term gains, in which tranche should s/he invest?

A)   Tranche I.

B)   Any of the tranches since mortgage-backed securities generally have a long duration.

C)   Tranche III.

Correct answer is C)        

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.

Q3. Which of the following statements about creating a collateralized mortgage obligation (CMO) is FALSE? A CMO:

A)   redistributes the risk between the tranches on an unequal basis.

B)   does not affect the overall risk of prepayment.

C)   redistributes the risk between the tranches on a random basis.

Correct answer is C)        

Creating a CMO usually redistributes the risk between the tranches on an unequal basis, not on a random basis.

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