ABS: Tranches & their risks

CFA Level I Fixed Income
#1

There is something that I don’t understand 100%. It’s about the Tranches and the Extensions & Contractions risks associated with them.

As far as I could read, if we have a sequential-pay CMO with two tranches (Tranch A and Tranch B). During the life of the ABS, both recieve interest payments but as Tranch A is the shorter one, its going to receive the principal payments first. Once this is done, Tranch B will start receiving the principal payments (so far, so good).

Since, contraction risk is the risk that the principal prepayment is faster than expected (by a decrease in the interest rate for example) and the extension risk is the risk that the principal prepayments are slower than expected (by an increase in the interest rate for example).

But, Tranch A has more “contraction risk” and the B has more “extension risk”. Can you explain me this please?

Thanks for reading

#2

Tranche A’s principal needs to be paid off first before the principal payments go to Tranche B so because of this, if interest rates decrease for example and people refinance their homes, there’s a much higher chance of the prepayments going to Tranche A since it is the first tranche in the CMO that needs to be paid off. Hope this helped.

#3

Thanks man. After re-reading the book and your answer, I could understand it.

#4

No problem man. Best of luck to you.