Table of Contents
CFA Level 2 – Fixed Income, Session 15-Reading 57
Mortgage-Backed Sector of the Bond Market-LOS h
(Notes, Practice Questions, Sample Questions)
1. $400 million of mortgage pass-throughs will be used as collateral for five tranches. The first two tranches are planned amortization tranches?$260 million of bonds of tranche U and $50 million of bonds of tranche V. Tranche U is a planned amortization class (PAC) I tranche and tranche V is a scheduled tranche. The third tranche is a scheduled support tranche—the holders of the $40 million of bonds in tranche W receive principal repayments according to a schedule as long as prepayment speed is between 190 and 240 PSA. The last two tranches are unscheduled floating-rate support tranches: $25 million of X bonds and $25 million of Y bonds. Which of the following statements regarding the prepayment risk of the bonds is most accurate? The:
A) U bonds have less prepayment risk than the V bonds, which have less prepayment risk than the Y bonds.
B) W bonds have less prepayment risk than the X bonds, which have less prepayment risk than the Y bonds.
C) W bonds have less prepayment risk than the U bonds, which have less prepayment risk than the Y bonds
Explanation: Even though U and V are sequential pay tranches, they are also PACs. Once the PSA rate is exceeded by the tranche collars the support tranches absorb all the prepayment risk first and then the prepayment risk is absorbed by the tranches in reverse order with the lower unscheduled tranches absorbing more prepayment risk before the higher scheduled tranches. Therefore tranche V would have more prepayment risk than tranche U. Support tranches X and Y have the greatest prepayment risk because they are unscheduled and lowest in the order of tranches; there is not enough information given to know which has higher prepayment risk. Tranche W will have less prepayment risk than X and Y, but more prepayment risk than V and U. Prepayment risk for PACs is highest at the lower tranches and lowest at the upper tranches
2. Two structures of collateralized mortgage obligations (CMO) are being considered. In the first structure, $300 million of pass-throughs will be used as collateral for two sequential-pay tranches: $225 million of bonds of tranche U and $75 million of bonds of tranche V. The principal for tranche U must be completely paid off before any payments are made to tranche V. In the second structure, the $300 million of pass-throughs will be used as collateral for $225 million of X bonds in a planned amortization tranche and $75 million of Y bonds in a support tranche. Which of the following is least accurate? The:
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A) X bonds have less contraction risk than the Y bonds.
B) U bonds have less contraction risk than the V bonds.
C) U bonds have less extension risk than the V bonds
Explanation: The U bonds have less extension risk, but they provide protection for the V bonds against contraction
3. Which of the following is most accurate for a companion tranche with a schedule of principal repayments? Such a companion tranche:
A) has greater protection against prepayment risk than a support tranche without a schedule of principal payments.
B) has no prepayment risk.
C) provides less protection against prepayment risk than a support tranche without a schedule of principal payments
Explanation: PAC II tranches are companion tranches having PAC prepayment schedules. Like regular PAC tranches, these scheduled support tranches receive a degree of prepayment risk protection at the expense of increased prepayment risk to other support tranches
4. Which of the following is referred to as a sequential-pay CMO? A sequential-pay CMO is structured so that each class of bond:
A) receives prepayments on a sequential pro-rata basis.
B) is retired sequentially.
C) has different credit risk
Explanation: When there are prepayments, the principal in the first bond class (tranche) is reduced until it is fully retired, then the principal of the next bond class is retired, and so on
5. $200 million of mortgage pass-throughs will be used as collateral for three tranches. The first two tranches are planned amortization class tranches: $110 million of bonds of tranche U and $50 million of bonds of tranche V. The third tranche consists of the holders of the $40 million of bonds in tranche W, which is a support tranche. Which of the following statements regarding the contraction risk and extension risk of the U bonds versus the V bonds is most accurate? The U bonds:
A) have less extension risk but not less contraction risk than the V bonds.
B) have less contraction risk and less extension risk than the V bonds.
C) have less contraction risk but not less extension risk than the V bonds
Explanation: The planned amortization portion of the tranches allows for the lower support tranches to absorb the prepayments first with the upper tranches having the least amount of prepayment risk with tranche V having more prepayment risk than tranche U because U is more senior than V. Because U has the least amount of prepayment risk it also has the least amount of contraction risk once again because all the lower subordinate tranches and support tranches absorb the prepayments first
