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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