IO CMO calculation of nominal amount

Does anyone know how to calculate nominal amount of Interest Only CMO?

(notional principal of orginal tranche * interest rate difference)/ interest rate for IO

If you’d like some intuition, just think of it as redirecting some of the interest of each tranche to the new IO tranche.

Using the formula from the above poster gives us the amount of interest (excess interest) from each tranche in absolute terms to be redirected. Then, to be consistent with the passthrough rate of the whole CMO, we just divide the sum of all this redirected interest by the passthrough to give us a hypothetical notional amount from which interest is paid.

thanks, it was very helpful!

I don’t think we have to know these calculations for the MBS/ABS. The CFAI LOS are only to understand the structures, risk distributions, valuation methods applied (IE: BSM or Binomial Interest Rate Model depending on path dependency). I’m almost certain you are wasting your efforts if working through those calculations. If you’re learning these for the benefit of extra knowledge, power to you, but if you’re just considering these because CFAI had some questions in their EOC (haven’t done them so just sort of assuming) and think it may be tested, I almost positive it won’t. That’s part of the issue with the CFAI EOC, there are many questions that won’t be tested which go to extra lengths.

Yes you are right. As I recall there is only one Q from this in EOC. I didn’t realize this, so many thanks to you. What about floater/inverse floater?

Same concept applies, just understand its characteristics. What are they by the way? I haven’t heard of those

Floater, Inverse floater - you just split up a tranche into 2 new tranches and bet them against each other. One pays out more if interest rates rise (floater) and the other pays less as rates rise (inverse). The opposite occurs when rates fall. Can’t remember the formulas, but they are set up to ensure the above relationship holds.

Its just another form of creating fixed income products out of a pool of mortgages.

Awwesome, thanks

Where exatly is this stuff on the CFAI texts?

I never saw this on schweser.