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CFA Level I · CFA Level I Exam · Fixed-Income Securitization

A CMO has a PAC tranche with a collar of 100% to 300% PSA. The collateral prepays at 450% PSA for several years, a speed above the upper band. Compared with prepayments inside the band, the PAC tranche's principal payments are most likely to:

The PAC tranche would most likely be paid early. Support tranches shield it only until they are retired. If prepayments run above the upper collar long enough to exhaust the support tranches, the extra principal flows to the PAC tranche, shortening its life and exposing it to contraction risk.

  1. ABe paid early, because the support tranches may be fully retired and no longer protect itCorrect
  2. BBe unaffected, since the PAC schedule is guaranteed at any speed
  3. CBe delayed, because the support tranches receive principal first

Explanation

Support tranches absorb excess prepayments only until their balances are exhausted. At sustained speeds above the upper collar, the support tranches can be retired, after which the PAC tranche receives the excess principal and is paid faster than scheduled. Support tranches do not receive principal ahead of the PAC when prepayments are high. The protection holds only within the band.

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