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

A CMO with a floating-rate tranche and an inverse floater tranche is created from a fixed-rate collateral pool. The structure most likely allows the issuer to:

The issuer can turn fixed-rate collateral cash flows into tranches with different interest rate sensitivities. The floater's coupon rises with the reference rate, while the inverse floater's coupon falls as the rate rises. This redistributes interest rate risk among investors but does not remove prepayment risk or improve loan quality.

  1. AEliminate prepayment risk from the collateral pool
  2. BConvert fixed-rate collateral cash flows into tranches with differing interest rate sensitivitiesCorrect
  3. CRaise the credit quality of the collateral by lowering the loan-to-value ratios

Explanation

The floater and inverse floater split fixed-rate coupon cash flows into a tranche that rises with the reference rate and one that falls with it. This redistributes interest rate risk but does not remove prepayment risk from the pool or change loan quality.

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