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

A sequential-pay CMO's Tranche A has the shortest expected maturity and Tranche C the longest. If interest rates fall sharply and prepayments rise well above the pricing speed, the average life of Tranche C is most likely to:

Tranche C's average life would most likely shorten, which is contraction risk. Falling interest rates speed up prepayments, so earlier tranches are retired faster and Tranche C starts receiving principal sooner. Extension risk is the opposite outcome and occurs when rising rates slow prepayments.

  1. ALengthen, exhibiting extension risk
  2. BRemain unchanged because Tranche A is paid first
  3. CShorten, exhibiting contraction riskCorrect

Explanation

Falling rates raise prepayments, so principal is returned faster and tranches are retired sooner. Tranche C is paid last, but with faster prepayments Tranches A and B retire sooner and C begins receiving principal earlier. Its average life therefore shortens, which is contraction risk. Extension risk arises when rates rise.

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