Which tranche has the most prepayment protection?

Last Update: April 20, 2022

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Asked by: Prof. Hailee Abernathy V
Score: 4.7/5 (55 votes)

At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years for tranche D. Tranche A has the highest contraction risk while tranche D has the highest extension risk. Tranches A and B provide protection against contraction risk for tranches C and D.

Which CMO tranche has the least certain repayment date?

The PAC, which is relieved of these risks, is given the most certain repayment date. The Companion, which absorbs these risks first, has the least certain repayment date. A Targeted Amortization Class (TAC) is like a PAC, but is only buffered for prepayment risk by the Companion; it is not buffered for extension risk.

Which CMO tranche has the lowest yield?

The prepayment and extension risk can be somewhat negated by a companion tranche, which assumes a greater degree of the risk. Because of the relative safety of PAC tranches, they usually have the lowest yields. Targeted amortization class (TAC) tranches: This CMO is the second-safest.

In which of the following tranche cash flows are more predictable?

The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk.

Which of the following is more susceptible to prepayment risk?

The prepayment risk is highest for fixed-income securities, such as callable bonds and mortgage-backed securities (MBS).

CFA Level I Fixed Income - Agency RMBS and Prepayment Risks

38 related questions found

Why is prepayment risk bad?

Why Does Prepayment Risk Matter? When a borrower prepays a loan, the borrower saves a lot of interest. But that means the lender also misses out on all that interest. Accordingly, prepayment can sometimes come with a penalty, and this is disclosed in the loan documents.

Which type of asset backed security is not affected by prepayment risk?

Which type of asset-backed security is not affected by prepayment risk? C. Because credit card receivable ABSS are backed by non-amortizing loans that do not involve scheduled principal repayments, they are not affected by prepayment risk.

Are CDOs still legal?

Yes, but: Today's synthetic CDOs are largely free from exposure to subprime mortgages, which drove much of the carnage in the crisis. Most are credit-default swaps on European and U.S. companies, and amount to bets on whether corporate defaults will increase in the near future.

What is prepayment risk?

Prepayment risk is a risk that banks can face if they grant homeowners the option to take advantage of lower mortgage interest rates by refinancing their mortgages on more favourable terms.

What is PAC tranche?

A planned amortization class (PAC) tranche is a sub-type of asset-backed security that is designed to protect investors from prepayment risk and extension risk. ... This range of prepayment speeds is referred to as the PAC collar.

Are CMOs a good investment?

How Risky Are CMOs? All investments come with risk. But CMOs are relatively safe investments because many of the mortgage loans in CMOs are insured by large mortgage investors such as Ginnie Mae, Fannie Mae or Freddie Mac. These loans, because of the agencies insuring them, generally carry a lower risk of default.

Do CMOs have prepayment risk?

With CMOs, the issuers can slice up predictable sources of income from the mortgages by using tranches, but like all MBS products, CMOs are still subject to some prepayment risk for investors. This is the risk that mortgages in the pool will be prepaid early, refinanced, and/or defaulted on.

Do strips have purchasing power risk?

STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is inflation, market interest rates are forced upwards, and zero-coupon bonds such as STRIPS fall dramatically in price (Treasury Receipts are broker-created zero-coupon bonds).

How often do CMOs pay interest?

For securities purchased at face value (“par”), these effects should be minimal. Because CMOs pay monthly or quarterly, as opposed to the semiannual interest payment schedule for most bonds, CMO investors can use their interest income much earlier than other bond investors.

What is the difference between CDO and CMO?

Collateralized Debt Obligations. Like CMOs, collateralized debt obligations (CDOs) consist of a group of loans bundled together and sold as an investment vehicle. However, whereas CMOs only contain mortgages, CDOs contain a range of loans such as car loans, credit cards, commercial loans, and even mortgages.

How is prepayment risk calculated?

Modeling the Prepayment Rate

Markets have adopted two main benchmarks that are used to track prepayment risk – the Conditional Prepayment Rate (CPR) and the Public Securities Association (PSA) prepayment benchmark.

What is prepayment example?

Prepayment refers to paying off an expense or debt obligation before the due date. ... Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.

How can prepayment risk be prevented?

Bond issuers can mitigate some prepayment risk by issuing what are called "super sinker" bonds. Super sinkers are usually home-financing bonds that repay bondholders their principal quickly if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity.

Do banks sell CDOs?

Banks sell CDOs to investors for three reasons: The funds they receive give them more cash to make new loans. It moves the loan's risk of default from the bank to the investors. CDOs give banks new and more profitable products to sell—boosting share prices and managers' bonuses.

Are CDOs making a comeback?

Now, CDOs are making a comeback. While the market is still a fraction of what it once was – today it stands at roughly $70 billion compared to more than $200 billion pre-crisis – major institutions like Citigroup and Deutsche Bank have skin in the CDO game once again.

Who invented CDOs?

Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Within 10 years, the CDO had become a major force in the so-called derivatives market, in which the value of a derivative is "derived" from the value of other assets.

Which is riskier ABS or MBS?

Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS. ABS also have credit risk, where they use senior-subordinate structures (called credit tranching) to deal with the risk. Valuing ABS and MBS can be done with various methods, including zero-volatility and option-adjusted spreads.

What is the prepayment penalty on a mortgage?

A prepayment penalty is a fee that your mortgage lender may charge if you: pay more than the allowed additional amount toward your mortgage. break your mortgage contract. ... pay back your entire mortgage before the end of your term, including when you sell your home.

What are the three factors that contribute to prepayment risk?

The earlier sections of the chapter highlighted the critical factors driving prepayment behavior, namely the level of interest rates, changes in home prices and price appreciation rates, and the level of real estate activity and sales.