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FRM Part II · FRM Exam Part II · Structured Credit Risk

A CMO is structured with a PAC tranche and a support tranche from the same collateral. Prepayment speeds unexpectedly increase well above the upper PAC collar. Which statement best describes the effect?

Support tranches absorb the excess prepayments, but if fast speeds persist beyond the upper collar and the supports are fully retired, the PAC tranche loses its protection. Its schedule is broken and its average life shortens, exposing investors to contraction risk.

  1. AThe PAC tranche's schedule is protected indefinitely because the support tranche never exhausts
  2. BOnce the support tranches are fully paid off, the PAC tranche's average life shortens and its schedule is brokenCorrect
  3. CThe support tranche's average life lengthens, because it receives prepayments later
  4. DThe PAC tranche absorbs all prepayment risk, while support tranches are unaffected

Explanation

Support tranches absorb excess prepayments first, so they shorten quickly. If speeds stay above the upper collar long enough, supports are retired and the PAC loses protection, so its average life contracts. Option 3 reverses the effect on support tranches.

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