investing in Tranche B of a CMO

Need help on this one: A portfolio consists of Treasury bonds, corporate bonds and Ginnie Mae passthroughs. The security being considered is Tranche B of a collateralized mortgage obligation (CMO). The underlying collateral is a Ginnie Mae passthrough security. The rules of the CMO state that Tranche A is the fist to receive monthly principal. By investing in Tranche B of the CMO, the portfolio manager will most likely reduce portfolio: A. Credit risk B. Inflation risk C. Sovereigh risk D. Prepayment risk Thx!

d. tranche A absorbs the early prepayments of principal, so the prepayment risk for tranche B is reduced.

I’m guessing D since Tranche A gets the prepayment $$$'s first. So if someone pays off their mortgage early or refi’s, Tranche A gets that hit first. Tranche B isn’t completely shielded but it should reduce the prepay risk. Sovereign risk is definitely wrong. Inflation risk isn’t addressed by this CMO. Let me know what the correct answer is.

Definitely D. The other risks are pretty much irrelevant. Now if they said C) contraction risk D) extension risk, there would be a real problem here. Note that Tranche B has less contraction risk than tranche A (like it won’t be paid off the minute interest rates drop a bit) but it has more extension risk than A.

whats contraction and extension risk?

WHAT … THEY HAVE CMO IN LEVEL ONE NOW???.. WOW… that was level 2 material

so they don’t have regression. In current environment, knowing about structured products is pretty important.

but then i wouldn’t think CMO is a fundamental background financial knowledge… you much rather know regression as a fundamental base… it’s stupid how they add in what they think it’s relevant. people can readit up on their own. it’s beyond the scope of level 1 i think…

They do have CMO stuff, but it’s very basic - this question is about the extent of it.