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

A planned amortization class (PAC) tranche is created within a CMO with a support (companion) tranche. Prepayment speeds then rise sharply well above the upper band of the PAC's protected range. Which outcome is most likely?

The support tranche absorbs the excess prepayments first, so its average life shortens sharply. If prepayments stay above the protected band long enough to exhaust the support tranche, the PAC loses its protection and its schedule cannot be maintained, so its average life shortens too.

  1. AThe PAC schedule continues to be met because the support tranche has been fully retired by the high prepayments and absorbs nothing further
  2. BThe support tranche absorbs the excess prepayments in the first instance, and if it is exhausted the PAC's schedule can no longer be maintainedCorrect
  3. CThe support tranche's average life lengthens because it receives principal later
  4. DThe PAC tranche's average life lengthens dramatically because its principal is deferred to the support tranche

Explanation

PAC protection works because support tranches absorb prepayment variability within the band. When prepayments exceed the band, the support tranche takes the excess and shortens, and once it is fully paid down the PAC loses protection and its average life shortens as well. The support tranche's average life shortens under fast prepayments, not lengthens.

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