LOS i: Evaluate the risk characteristics and the relative performance of each type of CMO tranche, given changes in the interest rate environment.

Q1. Which of the following statements regarding collateralized mortgage obligations (CMOs) is FALSE:

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

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

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

Q2. Which of the following explains why the companion tranches have the greatest prepayment risk in a CMO structure? The companion tranches:

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

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

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

Q3. Which of the following is FALSE regarding planned amortization class (PAC) versus support tranches?

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

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

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

LOS i: Evaluate the risk characteristics and the relative performance of each type of CMO tranche, given changes in the interest rate environment. fficeffice" />

Q1. Which of the following statements regarding collateralized mortgage obligations (CMOs) is FALSE:

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

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

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

Correct answer is A)

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.

Q2. Which of the following explains why the companion tranches have the greatest prepayment risk in a CMO structure? The companion tranches:

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

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

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

Correct answer is A)

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.

Q3. Which of the following is FALSE regarding planned amortization class (PAC) versus support tranches?

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

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

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

Correct answer is C)

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

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