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CFA Level I · CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

A CMO has a PAC tranche and a support tranche. If interest rates fall sharply and prepayments rise well above expectations, the support tranche is most likely to experience:

The support tranche's average life most likely shortens. Prepayments above the PAC schedule go to the support tranche, which retires faster, exposing it to heavy contraction risk. Its average life is the most volatile in the structure, because it absorbs variability to protect the PAC tranche.

  1. Aa shorter average life as it absorbs excess principal payments.Correct
  2. Ba longer average life because the PAC is paid first.
  3. Can unchanged average life because the PAC schedule is fixed.

Explanation

Excess prepayments beyond the PAC schedule are directed to the support tranche, so it is retired faster and its average life shortens (high contraction risk). The longer life would occur if prepayments slowed. The support tranche's life is the most variable, not unchanged.

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