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CFA Level I · CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

A floating-rate tranche is created in a CMO from fixed-rate collateral. To make the structure feasible, the issuer most likely also creates:

The issuer most likely creates an inverse floater tranche alongside the floater. The collateral pays fixed interest, so when the floater's coupon rises with the reference rate, the inverse floater's coupon must fall by an offsetting amount, keeping total interest owed within the collateral's cash flows.

  1. Aa zero-coupon tranche to offset the floater's interest payments.
  2. Ban inverse floater tranche whose coupon moves opposite to the reference rate.Correct
  3. Ca PAC tranche with a coupon equal to the reference rate.

Explanation

Collateral pays a fixed coupon, so the floater's rising coupon must be offset by an inverse floater whose coupon falls when the reference rate rises. Together, the combined coupons are supported by the collateral's fixed interest. A zero-coupon or PAC tranche does not provide this offset.

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