for sequential pay CMO, the last tranche to be paid principal also does not receive current interest until the other tranches have been paid off. this tranche is called the Z tranche. this accrual bond absorbs most of the prepayment risk in a sequential pay structure. so the first part says that the z tranche does not even receive interest but then the second part says that it absorbs the prepayment risk. what am i not understanding here?
its accepting the prepayment of principal, not interest… interest gets split up between the other tranches
The Z tranche does not receive cash interest but the interest is accrued to it just like a zero coupon bond. So the cash interest not paid to Z is used to pay off the other tranches principles in a sequential manner.
the interest on the accrual tranche is applied to the senior bonds as principal payment. So this reduces the prpayment risk since thay are receiving principal earlier in life. This same amount of interest accrues to the accrual tranche and is added to the principal balance.
You have to differenciate prepmt risk btw extension risk and contraction risk. The Z-tranche is exposed to extension risk but is pretected against contraction risk. The z-tranche is best for investors concerned about reinvestment risk.
prepayment risk has two types: contraction risk and extension risk. In this case, the short (senior) tranches takes lower extension risk but higher contraction risk. Z-bond actually has lower contraction risk but higher extension risk.
Deriv’s explanation sounds right to me, can someone confirm?
yes.
ok this makes sense now…somehow i thought prepayment risk was only contraction risk…so sick of all this! thanks all!