Contraction Risk Trick Question?

I thought this one was a trick question, because when you include Z-Tranches (Accrual Tranches) the average life of the earlier bonds goes lower (See table bottom page 350 in CFAI V5). This is because those prin payment are coming from Z-Tranche. So, if prin payments come in earlier, the avg. life drop won’t won’t be as big on A,B,C. If they come in very early, the Z-tranche avg. life will drop a lot more than expected. Thus, it would have the greatest contraction risk. Everyone on this forum is says A-Tranche, but I am not so sure. Please reference CFAI texts to prove your points.

was it related to the sequential pay structure question? .If it is sequential pay strucutre Tranche A will have more contraction risk.

It was a sequential pay structure. Answer was tranche A

Where exactly in the CFAI text does it say this? I have heard shweser people say this but I have only studied from the CFAI and I cannot find it. I have gotten a hold of a Fabozzi book which shows the greatest change in avg. life (% of avg. life) from prepayments is the Z-Tranche. I am not saying I’m right (I have a -1 in my mind for this) but I would just like to see the proof so I can put this to bed. And yes, I trade Bull Se&*%!

i think the inverse floater is a subordinated tranche, which means it eats the defaults, not prepayment risk… so it will have more default risk, but not necessariy contraction risk… since A is being paid off before the inverse floater, it will have more contraction risk… hope this helps… -1 for me too, but i understand why now thanks to AF

OK, A is being paid off earlier, but so will the Z-tranche (eventually). So the A goes from a WAL of 1.5 to 1.1, but the Z-Tranche WAL goes from 22 to 11. I would say Z-Tranche has greater contraction risk. ****Sound of dead horse being beaten****

its not a z-tranche tho… z-tranche is an accrual tranche… inverse flaoter is not an accrual tranche, just a subordinated tranche

yes, that’s my point, I was saying Z-Tranche (Accrual Bond) was the correct answer. One lone voice in the storm screaming Accrual!!! I don’t think I can find one person to agree with me, but no one has shown me where in the CFAI I’m wrong.

Where is the info you have on WAL coming from? Was that from the actual test or somewhere in the books? Regardless, the A Tranche has the most contraction risk. See CFAI V5 page 352 exhibit 10, footnote 2 on disbursement of principle payments. In my view this should settle it. Disburse principle payments to tranche A until it is completely paid off. After tranche A is completely paid off, disburse principle payments to tranche B until it is completely paid off. After tranche B is completely paid off, disburse principal payments to tranches FL and IFL until they are completely paid off. The principle payments between tranches FL and IFL should be made in the following way: 75% to FL and 25% to IFL. After tranches FL and IFL are completely paid off, disburse principal payments to tranche Z until the orig balance plus accrued interest are completetly paid off. Unless I am forgetting something from the question, no two ways about it, the A tranche is exposed to the most contraction risk. I remember it as a sequential pay structure and not a PAC.

Accrual tranches do not absorb prepayments. Are you thinking of support tranches?

Where does it say contraction risk in your statement. I read that last night too. My point comes from Fabozzi book which the CFAI references. If the question asked, who gets paid first, then I completely agree. But it asked for contraction risk. I say a bond going from WAL of 22 to 11 has a higher risk than 1.5 to 1.

I put Accrual as well on the test… but after reading everyone’s arguments (and the fact that i can barely remember the vignette or question) i think i’m wrong. But you give me hope comcast! haha

Agreed they do not “absorb” prepayments, but if prepayments comes in faster, then the whole structure pays sooner and it has the greatest effect on the WAL of the Z-tranche, so in my mind that has the greatest contraction risk. AAAHHHH. I read way too much into question I bet. Which nicely offsets my not reading enough into other questions. I am killing this thread, like Vick kills…what too soon?

My understanding of contraction risk is a shortening of duration as a result of prepayment. I agree with you statements about WAL’s but where does this come from? Was that in the question? I can’t remember.

was there any info relating to PSA measurement for this question?

not too my recollection… it was a theory question… we cant keep harping here… just give yourself half a point and move on with summer…

Not to be a dcik but you don’t have to post anything or read any of these posts if you don’ t want to harp.

If i remember correctly the Asia paper asked for the least contraction risk…options were A b1 and B2. Anybody with me?

Too much debate for a relatively easy concept…

In a sequential pay bond tranches are protected from contraction risk from senior tranches. CHeck out Fabozi’s book (Fixed Income analysis) page 276. to quote Fabozzi "…, tranches C and D provide protection against extension risk for transches A and B. At the same time, tranches C and D benefit because they are provided protection against contraction risk, the protection coming from tranches A and B. js - I agree with your analysis on the WAL but I do not think those numbers are representitive of a standard sequential pay MBS.