LOS g: Illustrate how a collateralized mortgage obligation (CMO) is created and how it provides a better matching of assets and liabilities for institutional investors.

Q1. How is a collateralized mortgage obligation (CMO) created? A CMO is created by:

A)   eliminating prepayment risk.

B)   redistributing the cash flows of mortgage-related products to different bond classes.

C)   eliminating extension risk.

Q2. Which of the following best describes how planned amortization class (PAC) bonds are protected against prepayment risk to create products that provide better asset and liability matching for institutional investors? PAC bonds:

A)   accrue the interest for one tranche and redistribute it to the support tranches.

B)   have a fixed principal repayment schedule that must be satisfied as long as the support tranches exist.

C)   have several different companion tranches to which repayments are directed sequentially.

Q3. Which of the following statements regarding CMOs is FALSE? The:

A)   early maturing tranches offer relatively greater protection against extension risk.

B)   longer-term tranches offer relatively greater protection against contraction risk.

C)   early maturing tranches offer relatively greater protection against contraction risk.

Q4. Which of the following best describes how accrual bonds distribute prepayment risk among tranches to create products that provide better asset and liability matching for institutional investors? Accrual bonds:

A)   have a fixed principal repayment schedule that must be satisfied as long as the support tranches exist.

B)   accrue the interest for one tranche and redistribute it to the other tranches.

C)   have several different tranches to which accrued interest is directed sequentially.

LOS g: Illustrate how a collateralized mortgage obligation (CMO) is created and how it provides a better matching of assets and liabilities for institutional investors. fficeffice" />

Q1. How is a collateralized mortgage obligation (CMO) created? A CMO is created by:

A)   eliminating prepayment risk.

B)   redistributing the cash flows of mortgage-related products to different bond classes.

C)   eliminating extension risk.

Correct answer is B)        

Creating CMO's distributes the various forms of prepayment risk among different classes of bondholders which allows the CMO to more closely satisfy the asset/liability needs of institutional

investors.

Q2. Which of the following best describes how planned amortization class (PAC) bonds are protected against prepayment risk to create products that provide better asset and liability matching for institutional investors? PAC bonds:

A)   accrue the interest for one tranche and redistribute it to the support tranches.

B)   have a fixed principal repayment schedule that must be satisfied as long as the support tranches exist.

C)   have several different companion tranches to which repayments are directed sequentially.

Correct answer is B)        

The PAC tranche has significant protection against prepayment risk at the expense of the support or companion tranches.

Q3. Which of the following statements regarding CMOs is FALSE? The:

A)   early maturing tranches offer relatively greater protection against extension risk.

B)   longer-term tranches offer relatively greater protection against contraction risk.

C)   early maturing tranches offer relatively greater protection against contraction risk.

Correct answer is C)

The early maturing tranches offer relatively greater protection against extension risk, not contraction risk.

Q4. Which of the following best describes how accrual bonds distribute prepayment risk among tranches to create products that provide better asset and liability matching for institutional investors? Accrual bonds:

A)   have a fixed principal repayment schedule that must be satisfied as long as the support tranches exist.

B)   accrue the interest for one tranche and redistribute it to the other tranches.

C)   have several different tranches to which accrued interest is directed sequentially.

Correct answer is B)        

For many sequential-pay CMO structures, the last tranche to be paid principal also does not receive current interest until the other tranches have been paid off. This tranche is called the Z-tranche or accrual tranche, and the securities that represent a claim against its cash flows are called Z-bonds or accrual bonds. The interest that would ordinarily be paid to the accrual tranche is applied against the outstanding principal of the other tranches, in sequence. The diverted interest from the accrual tranche accrues. That is, it is added to the outstanding principal balance of the Z-tranche.

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