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FRM Part II · FRM Exam Part II · Structured Credit Risk

In a sequential-pay CMO built from a mortgage pass-through pool, tranches A, B and C are paid principal in that order. Which statement best describes the effect on tranche A if prepayments unexpectedly accelerate?

Tranche A's average life shortens substantially. In a sequential-pay CMO, all principal payments, including prepayments, go first to the earliest tranche until it is retired. Faster prepayments therefore pay off tranche A earlier, while later tranches are affected indirectly.

  1. ATranche A's average life shortens substantially, because all prepaid principal is directed to it firstCorrect
  2. BTranche A's average life lengthens, because prepayments are redirected to tranche C
  3. CTranche A's average life is unchanged, because tranches share principal pro rata
  4. DTranche A's coupon is reduced because prepayments lower the pool's weighted average coupon

Explanation

In a sequential structure, all principal, scheduled and prepaid, goes to the first outstanding tranche until it is retired. Faster prepayments therefore retire tranche A sooner and shorten its average life. Pro rata sharing is not the sequential-pay rule, and prepayments do not go to tranche C first.

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