SeanWest

please see the numerical example in the text... also there is a problem in the EOC related to this...

see how the principal from Z_tranche moves to the Senior tranche. compare senior tranche in the two examples - one with a straight subordinate tranche, other with the z-tranche, and see how the principal payment window on the PAC tranche changes due to the presence of the z-tranche.

Senior tranche in the case where it is a straight subordinate tranche has different investment needs from the senior tranche where a z-tranche is present. Their timing and need for cashflows and their risk appetites are different.

CP

MiniMe7

francisgy, I was writing you a message and then my browser shuts off.

I come back to see that cpk has written what I was going to.

His last paragraph is what you need to understand. I would invest in a particular tranche only if I had some particular view of the interest rate movement and depending on my need of cash flows.

Otabek

z tranche is there so as to mitigate extension risk for senior tranches. z tranches are there because there are demand for them.

mengxu

Not to add fuel to this fire but I had a similar question and I figured I'd post it in this thread. EOC question in reading 57, #27

A sequential pay collaterized mortgage obligation (CMO) with an accrual tranche lowers the prepayment risk and shortens the average life of the sequential pay tranches relative to a sequential pay CMO without an accrual tranche.

Is this conclusion correct
A. Yes
B. No, because an accrual tranche increase prepayment risk
C. No, because an accrual tranche has no effect on prepayment risk

The answer is C: An accrual tranche (Z tranche) is paid only after all other tranches have been paid in full. Thus, a Z tranche acts as a zero coupon, single payment at maturity bond. The existence of an accrual tranche has no effect on prepayments.

Now this question is a big confusing, if your looking at it from the perspective of the borrower, thats correct, you could have as many tranches as you want, the prepayment risk would be dependenton interest rate paths. But what I don't understand is, if you add an accrual tranche (Z-tranche) your rerouting interest payments from the tranche to the other sequential tranches principal, and hence, you get a faster prepayment rate on the sequential tranches effectively increasing Prepayment or contraction risk.



Edited 3 time(s). Last edit at Tuesday, March 23, 2010 at 01:07AM by dtrynoski.

mp3bu

dtrynoski

I too got this question wrong, when I had done it. Crucial term to understand is prepayment risk.

All in all, interest is diverted from the Z-Tranche to the Sequential CMO tranches. But that is known well before the investor invests in the tranches. Average life on the tranches is lower than what it would have been without a Z-Tranche. But all that is really before the fact. That really has no impact on the Prepayment risk. As you have said above, Prepayment risk is affected by the actual interest rate environment. Interest rate could reduce, More than normal prepayments could occur, and the Sequential CMO tranches could still contract. So there is NO IMPACT on prepayment risk as a result of the Z-Tranche.

CP

Newhuman

That's a weird question, although I salute cpk for the explanation. The confusion comes from the second part of the question where it says "...relative to a sequential pay CMO without an accrual tranche.". Also, one tends to think of the Z tranche as a "support" tranche, which it isn't. So, it seemed to be comparing one structure with a Z and another structure without a Z...sure as hell, I would've gotten this wrong!



Edited 1 time(s). Last edit at Thursday, May 13, 2010 at 05:58PM by Dreary.

BelalM

The tranche lowers contraction risk not prepayment risk for the other tranches

senlinlang

max81 Wrote:
-------------------------------------------------------
> The tranche lowers contraction risk not
> prepayment risk for the other tranches


Fair enough, but what is the difference between the two?

NO EXCUSES

wxs1986

bpdulog Wrote:
-------------------------------------------------------
> max81 Wrote:
> --------------------------------------------------
> -----
> > The tranche lowers contraction risk not
> > prepayment risk for the other tranches
>
>
> Fair enough, but what is the difference between
> the two?


These two should be the same