Would someone be able to explain the difference between these two? I dont quite understand which is important, when it changes etc… From fixed Income investments 1 - re: the Planned Amortization Class (PAC) tranche on an MBS. Tks
Basically initial collar is calculated based on expected prepayment patterns. Once the tranches are issued, if the actual prepayment rate is lower(higher) than the expected rate the collar will widen(narrow). This new collar is called the effective collar. Therefore, if an investor is buying PAC securities in the secondary market, the effective collar is the appropriate measure of his/her prepayment protection.
ok cool thanks. Why does the collar widen if the expected prepayment rate (is this the same as the CPR?) is lower?
CPR stands for conditional prepayment rate, and yes is essentially used as expected prepayment rate. If prepayment is lower than the value of the pool of obligations increases. To find the collar you first need to know what units your boundary is in, which is called PSA [Public Securities Association (this is metric for projecting prepayments over life of pool)] higher the PSA, the higher projected prepayments and lower the value of the pool. In the book, it gives the example of a collar of 90-350PSA. If the pool hovers around 90 for the first 10 years, then it hasd been at the lower end of the PSA range. Therefore, if in year 11 it goes to 375, it is not immediately going to change the averge life of the PAC tranche, because it has built up a lot of support. In essence the collar has widened, because now the support tranche is stronger than before because of less prepayment in the past. the support is there to eat up the prepayment risk. Sorry it got wordy… kind of confusing… CFAI does a decent job explaining it…
Just off the top of my head, so feel free to correct me if something doesn’t make sense. A PAC has a collar associated with it, which specifies what the expected prepayment rate would be. This collar is the initial collar. At certain point during the life of the PAC, the amount of actual prepayment would be known. If the actual prepayment tends to approach the upper collar, then one would expect later on, the PAC would have less protection from the supporting tranches. Similar logic applies if the prepayment tends to approach the lower collar. So to find out how much protection is available for the PAC during its life, an effective collar is computed based on the amount of prepayment left. This is a more realistic measure of how much protection is available to the PAC than using the initial collar. So, if the actual prepayment approaches the upper end of the initial collar, we would expect the effective collar to be narrower. Similarly, if the actual prepayment approaches the lower end of the initial collar, we would expect the effective collar to be wider (more cushion is available to the PAC than originally expected).
eltia, that sounds right to me… It is confusing but i think you got it