So, I understand how a the support tranche can accept contraction risk by simply accepting the prepayments before the PAC but what is the mechanism for the support tranche to accept the extension risk? The only thing I can think of is that if rates go higher then the support tranche will redirect interest cash flows to keep the PAC within the collar. Is that right or am I missing something?
Haven’t revised this yet but I guess it would work like this: Contraction risk = prepayments are more than expected = payments get redirected to the support tranche from the PAC tranche Extension risk = prepayments are less than expected = payments get redirected to PAC tranche from support tranche.
Thanks did figure it out. The support redirects principle payments from the support to the PAC to keep it within the collar