cityboy

6. A fixed income portfolio manager is evaluating investments in the mortgage market but is concerned about prepayment risk. The security that will most likely minimize prepayment risk is: A. a mortgage passthrough security. B. a portfolio of interest-only mortgage loans. C. tranche B of a collateralized mortgage obligation.

Ans: C; C is correct because a collateralized mortgage obligation or CMO, is structured to distribute prepayment risk among different tranches of bonds. Tranche A would be repaid first, followed by tranche B, then C, etc. A is not correct. A mortgage passthrough security passes the payments made on a pool of mortgogages through proportionally to each security holder. A holder of a mortgage passthrough security that owns a 1% portion of the issue will receive 1% share of all the monthly cash flows from all the mortgages. Since each holder receives a percentage of all cash flows, a mortgage passthrough security has prepayment risk as a single mortgage would. B is not correct. A holder of a portfolio of interest-only mortgage loans will receive less total payments when prepayment rates are higher since interest is only paid on the outstanding principal amount, which is decreased by prepayments. It does not minimize prepayment risk.

cityboy

5. The primary motivation for creating a collateralized mortgage obligation (CMO) is best described as the desire to redistribute which risk of investment in residential mortgages: A. interest rate risk. B. default risk. C. prepayment risk.

Ans: C; C is correct because the motivation for creating a CMO is to distribute prepayment risk among different classes of bonds.

cityboy

4. A level payment, fixed-rate, fully amortizing mortgage loan for $220,000 is obtained with a term of 15 years, a mortgage rate of 6.0% with monthly compounding, and a monthly payment of $1,856.49. Assuming that the borrower does not prepay or default, the principal that is repaid during the first 3 months is closest to: A. $660. B. $2,281. C. $3,667.

Ans: B; Mon Beg. Balance Mortgage Payment Interest Principal Payment Ending Balance 1 220,000.00 1,856.49 1,100.00 756.49 219,243.51 2 219,243.51 1,856.49 1,096.22 760.27 218,483.24 3 218,483.24 1,856.49 1,092.42 764.07 217,719.17 Principal repaid the first 3 months =$756.49+760.27+764.07 =$2,280.83

cityboy

3. An investor is considering floating-rate debt and other investments to protect against unexpected increases in inflation. Her friend states: 1) Treasury Inflation Protected Securities (TIPS) is suitable because the coupon rate is adjusted for inflation semiannually. 2) On-the-run Treasury issues have narrower bid-ask spreads than other Treasury issues. A. Only statement 1 is correct. B. Only statement 2 is correct. C. Both statement 1 and 2 are correct.

Ans: B; The friend is incorrect about TIPS because the coupon is fixed and par value is adjusted for inflation. The friend is correct about the bid-ask spread for the on-the-run issues because they are more liquid and, thus, have a narrower-bid-ask spread.

cityboy

2. All U.S. Treasury coupon strips are: A. zero-coupon securities. B. issued directly by the U.S. Treasury. C. created from pooled coupon payments of U.S. Treasury securities.

Ans: A; A is correct. Since the U.S. Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand. B is not correct because Treasury strips are not issued directly by the U.S. Treasury but are stripped from the principal or interest payments of U.S. Treasury securities become direct obligations of the U.S. government. C is not correct because Treasury coupon strips are strips created from coupon payments stripped from the original security.