onelife1

Here's what is tripping me up.

The purpose of the collar it to mitigate prepayment risk -- contractions and extensions. Conceptually, this works so long as actual prepayments fall within the effective collar.

What confuses me is the fact that the PAC normally receives the minimum side of the collar band, not some other point in the band. To my understanding, this protects contraction risk only (prepayments inside the collar will always exceed the minimum). Extension risk is only mitigated when prepayments fall below the lower bound, and by definition you're outside the collar.

So how does this structure reduce extension risk for PAC holders?

- Robert