CFA Level I · CFA Level I Exam · Fixed-Income Securitization
In a sequential-pay CMO with Tranches A, B and C, all principal payments, including prepayments, are first directed to Tranche A. Which tranche is most likely to have the greatest extension risk?
Tranche C, the last in the sequence, has the greatest extension risk. It receives principal only after Tranches A and B are fully retired, so slower prepayments when rates rise delay its payments and lengthen its life the most.
- ATranche A
- BTranche B
- CTranche CCorrect
Explanation
Tranche C receives principal only after A and B are retired. If rates rise and prepayments slow, the retirement of A and B takes longer, pushing C's expected maturity further out. Tranche A is the most exposed to contraction risk.
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