# CMO Tranches; Extension Risk & Contraction Risk

Keep getting confused with this concept when I try and apply it to an actual CMO. The basics are clear; if you own a passthrough with 5% coupon and interest rates go down to 2%, theres an incentive for people to refinance their loans and thus pre-pay principle. You get stuck with more money when you dont want it (when rates are low). On the flip side, if rates go up, people slow down pre-payment and you face extension risk - you get less money precisely when you want it (rates are now higher). Kinda screwed either way. With respect to tranches, I’m looking at the simplest form so its easy to comprehend (Sequential Pay - R57 pg. 373). Theres 4 tranches, A, B, C, D all with same 7.5% coupon rate. So payments come in and everybody gets their interest of 7.5% but the entire amount of principle goes to reduce the balance in tranche A. If prepayments occur, the balance in ‘A’ gets paid down faster. If prepayments slow down, everybody still gets paid, just the guys at the end tranches C, D are worse off because their investments wont be paid off until longer than expected. My conclusion is, senior tranches are exposed to extension risk & junior tranches are exposed to contraction risk. Somebody please confirm I’m not looney. Matt

mbolzicco Wrote: ------------------------------------------------------- > So payments come in and everybody gets > their interest of 7.5% but the entire amount of > principle goes to reduce the balance in tranche A. > If prepayments occur, the balance in ‘A’ gets > paid down faster. In this sense does it face > contraction risk? Yes > If prepayments slow down, > everybody still gets paid, just the guys at the > end tranches C, D are worse off because their > investments wont be paid off until longer than > expected. > Yes, but I wouldn’t say they are worse off. They are probably better off. If they are clipping coupons at 7.5% when rates have fallen to 2% (and no one is prepaying), they are partying like it’s 1999.

Well ‘worse off’ in a sense because they were expecting to clip 7.5% coupons for 25 years so there was more interest in the pool for the takin’. Now rates have gone down, and people prepay, there is less interest for everybody and they will be clipping 7.5% coupons only for say, 21 years due to contraction risk. In that sense they are ‘worse off’ is what I meant.

Its a wrong conclusion because senior tranche give proction to junior tranche for contanction risk…because when interest rate goes down they are prepayment increases and senior tranches completely paid with reduced average life so they are exposed to greater contraction risk. And Junior tranche have more extension risk, because with the increase in interest rates, prepayment will be slow down and it will take longer to paid off senior tranche and average life exteds which will increase the extension risk for junior tranche.

Ok so senior tranches that get paid off faster face contraction risk, and are protected against extension risk. Junior tranches are protected against contraction risk, but face extension risk.

>My conclusion is, senior tranches are exposed to extension risk & junior tranches are exposed to >contraction risk. Somebody please confirm I’m not looney. Not sure how you got that conclusion from your reasoning (which is spot on). the exact opposite is true. If Interest rates drop, senior tranches gets paid first, hence they have risk of contraction.