Accrual tranches and prepayment risk principal, everyone, exchange, presence, solution

JonnyKay

According to the solution to EOC problem 27 in reading 57, the presence of an accrual tranche does not impact prepayment risk. How can that be? Accrual tranches get paid principal after everyone else, so aren't they laying off contraction risk to the other tranches in exchange for extension risk?

scarecrow

Actually I think the life for the senior tranches gets shorter due to the accrual tranche as the interest payments flow to the senior ones. I believe there is less extension risk...

Uranus08

Accrual tranches shorten the lives of prior tranches. The interest payments meant for the accrual tranche are instead diverted to pay down earlier tranche principal. It creates a shorter life group of tranches and a long (accrual) tranche. I guess in this case the lower tranches provide protection against extension risk, and according to the text, the z tranche is providing protection against reinvestment risk.

I suppose reinvestment risk would be similar to prepayment risk, because the fundamental risk behind contraction is reinvestment risk.


See page 387-388 CFAI fixed income book

chandsingh

I think that is backwards - the z tranche is *protected against* reinvestment risk, because it receives no principal or interest until the end. It is like a funky 0-coupon bond. Because it receives no principal until the end, it still seems to me that the other tranches have increased prepayment risk and the accrual/z tranche has more extension risk.

Houjichasan

Photoguy is correct with regards to reinvestment risk

b_sea93

The support tranche has more extension and contraction risk. They provide the prepayment protection to the pac tranches. Photoguy is right about reinvestment risk as they don't get their principal until the end. Still, if there is very high/low prepayment, the pac tranches will face some contraction/extension risk, but as the support is the buffer, it'll take the hit first.