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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 with a prepayment collar of 100% to 300% PSA. If prepayments run persistently at 450% PSA and the support tranches are fully retired early, the PAC tranche is most likely to:

The PAC tranche would face contraction risk. Its protection depends on support tranches absorbing excess principal, and once they are retired with speeds above the upper collar, the PAC receives principal faster than scheduled. Extension risk would arise only if prepayments fell below the lower band.

  1. Akeep its planned schedule because the collar is permanent.
  2. Bexperience extension risk because principal arrives later than scheduled.
  3. Cexperience contraction risk because principal arrives faster than scheduled.Correct

Explanation

The PAC schedule is protected only while support tranches remain outstanding and speeds stay in the collar. Once supports are retired and speeds exceed the upper band, the PAC receives principal faster than planned, which is contraction risk. Extension arises when speeds fall below the lower band.

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