Reading 58: LOS j ～ Q1- 3

1.Which of the following is FALSE regarding planned amortization class (PAC) versus support tranches?

A)   The PAC tranches have the greatest prepayment risk in the collateralized mortgage obligation (CMO) structure.

B)   There is an inverse relationship between the prepayment risk of the PAC tranches and the prepayment risk associated with the support tranches.

C)   When support tranches are paid off and the principal then goes to the PAC holders, it is referred to as a broken or busted PAC.

D)   The prepayment risk protection provided by the support tranches causes the average life to extend and contract.

The correct answer was A)

The support tranches have the greatest prepayment risk in the CMO structure, not the PAC tranches.

2.Which of the following explains why the companion tranches have the greatest prepayment risk in a CMO structure? The companion tranches:

A)   are more interest rate sensitive and therefore prepayment risk is higher.

B)   have to support any principal payments in excess of the scheduled principal payments.

C)   receive higher fixed coupon interest so prepayment risk is higher.

D)   consist of underlying mortgages for which prepayment is allowed, as opposed to the PAC tranches.

The correct answer was B)

There is an inverse relationship between the prepayment risk of PAC tranches and the prepayment risk associated with the support tranches. In other words, the certainty of PAC bond cash flow comes at the expense of increased risk to the support tranches.

3.Which of the following statements regarding collateralized mortgage obligations (CMOs) is FALSE:

A)   CMOs are securities issued against passthrough securities for which the cash flows have been reallocated to different bond classes called tranches.

B)   A sequential-pay CMO is a structure whereby each class of bond is retired sequentially.

C)   The Z-tranche or accrual tranche does not receive current interest until the other tranches have been paid off.

D)   CMOs perfectly protect investors against contraction risk but do not protect against extension risk.

The correct answer was D)

CMOs do not perfectly protect investors against contraction risk. They offer some protection against both contraction and extension risks, but not perfect protection against either.