Contraction vs extension and support tranches

CFA Level II
#1

I have a hard time wrapping myself around thoses concepts in fixed income so here is my understanding:

Contraction risk: Risk of increasing interest rate which will prompt refinancing and prepayment risk

Extension risk: Risk of decreasing interest rate which will reduce prepayment risk.

Support tranches: Absord prepayment risk and extention risk (how can absord both risk at the same time?)

Junior vs senior tranches: Segment a CMO so that investor can choose their their favorite tranches. Senior tranche have less default risk but trade off is more prepayment risk. Junior tranches have more default risk but less contraction risk.

In general senior tranches have higher spread, seems to me that senior tranches are better than junior tranches. Senior tranches must be traded at a premium versus junior tranches…

Please feel free to correct my analysis.

Thanks and good luck everyone.

#2

Support tranches: Absord prepayment risk and extention risk (how can absord both risk at the same time?)

they dont absorb them at the same tym, it depends, if int rates are low they absorb the contraction risk and if int rates are high they absorb the extension risk…

Senior tranche have less default risk but trade off is more prepayment risk. Junior tranches have more default risk but less contraction risk.

true statement

seems to me that senior tranches are better than junior tranches. Senior tranches must be traded at a premium versus junior tranches…

right again my man…either that our juniors have higher yeilds as compared to seniors…

Best of luck…

P.S. lve ur user id

#3

Extension Risk is when interest rates INCREASE… Due to which prepayments slow down!

#4

These two are flipped. Refinancing occurs when intesrest rates fall.

#5

Contraction risk: Risk of DECREASING interest rate which will prompt refinancing and prepayment risk

Extension risk: Risk of INCREASING interest rate which will reduce prepayment risk.

Support tranches: Absorbs prepayment risk act , as a buffer for CMO - As GYAN mentioned above if the interest rates are above or below PAC Band (interest rate band)

Junior vs senior tranches: Segment a CMO so that investor can choose their their favorite tranches. Senior tranche have less default risk but trade off is more prepayment risk. Junior tranches have more default risk but less contraction risk.

In general senior tranches have higher spread, seems to me that senior tranches are better than junior tranches. Senior tranches must be traded at a premium versus junior tranches…