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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A risk manager compares a pass-through agency MBS with a sequential-pay CMO built from the same collateral. Which statement is correct?

Pass-through investors share pool cash flows pro rata, while sequential CMO tranches receive principal in a priority order. This redistributes prepayment and extension risk across tranches, giving different average lives, but it does not eliminate prepayment risk for the pool.

  1. APass-through holders receive a pro rata share of principal and interest, while CMO tranches receive principal in a set priority orderCorrect
  2. BCMO structures eliminate prepayment risk for the whole pool
  3. CPass-through holders receive principal only after all CMO tranches are repaid
  4. DCMO tranches all have identical average lives

Explanation

A pass-through distributes interest and principal, including prepayments, pro rata to investors. A sequential CMO redirects principal to tranches in order, shifting the timing of prepayment risk. It does not remove the risk, because the total pool risk is only redistributed, and average lives differ by tranche.

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