# more on contraction and extension risk

\$200 million of mortgage pass-throughs will be used as collateral for three tranches. The first two tranches are planned amortization class tranches: \$110 million of bonds of tranche U and \$50 million of bonds of tranche V. The third tranche consists of the holders of the \$40 million of bonds in tranche W, which is a support tranche. Which of the following statements regarding the contraction risk and extension risk of the U bonds versus the V bonds is TRUE? The U bonds: A) have less contraction risk but not less extension risk than the V bonds. B) have less contraction risk and less extension risk than the V bonds. C) have less extension risk but not less contraction risk than the V bonds. D) do not have less contraction risk or less extension risk than the V bonds.

My Take is B) have less contraction risk and less extension risk than the V bonds

Well… It’s pretty late, But I might give it a try… 200m total U = PAC(110m) V = PAC(40m) W = Support(50m) Consider contraction - fast payments, most of them absorbed by Support-W, if prepayments overshoot it’s capacity, they start falling into V, and then finally go to U. So probably U < V < W contraction risk Consider extension - slow payments, U needs to maintain it’s schedule, pulls money from V and W. So again U < V < W extension risk Will go with B here.

you guys got it… i didnt get the concept right until today :S

yay! I got a cake for ya - wanna some? FCFF models are more suitable than FCFE models for valuing firms that are in the process of changing their capital structure for all of the following reasons EXCEPT: A) value of equity is small compared to the total value of the firm and is sensitive to the assumptions of growth and risk. B) volatility due to debt payments makes it difficult to estimate FCFE. C) operating earnings will not be affected by the change in capital structure. D) these firms will have negative FCFE.

If I were to guess, i’ll say B. Although i think i am wrong.

'morning Dinesh. I will guess C. The FCFE is not necessarily negative just because the firm is changing capital structure. They could be borrowing more money which would make it positive.

I’m going D here too… I can’t see why the FCFE would necessarily be negative.

I meant to put D for the reasoning I listed above.

D same reasoning

Answer to my cake question was candle D