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

A planned amortization class (PAC) tranche is created within a CMO. The support tranches most likely provide protection to the PAC tranche by:

Support tranches shield the PAC tranche by absorbing prepayment variability. When prepayments exceed the schedule, support tranches take the extra principal, and when prepayments fall short, they are paid later. This keeps PAC principal payments on schedule within the initial collar, at the cost of more risk for the support tranches.

  1. AReceiving interest payments ahead of the PAC tranche
  2. BAbsorbing excess prepayments and shortfalls relative to the PAC scheduleCorrect
  3. CGuaranteeing the PAC tranche a fixed prepayment speed for any interest rate path

Explanation

PAC tranches have a scheduled principal payment within a band of prepayment speeds. Support tranches absorb prepayments above the schedule and supply less when prepayments are slow, so PAC cash flows are stabilized. They do not guarantee a prepayment speed, which depends on borrowers.

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