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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A CMO structure has a PAC tranche and a support tranche. Compared with the PAC tranche, the support tranche is best described as:

The support tranche carries greater prepayment risk. It absorbs prepayment deviations so the PAC tranche can follow its planned schedule within the prepayment band. Its principal receipts and average life therefore vary much more than those of the PAC tranche.

  1. ASubject to less prepayment risk because it absorbs the payments first
  2. BSubject to greater prepayment risk because it absorbs deviations from the PAC scheduleCorrect
  3. CExposed to the same prepayment risk because both are backed by the same collateral
  4. DExposed to no prepayment risk because its coupon is floating

Explanation

A PAC tranche has a scheduled principal payment within a band of prepayment speeds. Support (companion) tranches absorb excess principal when prepayments are fast and receive less when they are slow. This makes their cash flows and average life much more variable. The floating coupon does not remove prepayment risk.

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