I came across the following statement in my studies:
“There is an inverse relationship between the prepayment risk of the PAC tranches and the prepayment risk associated with the support tranches.”
I don’t understand this logic. My thinking is that there should be a direct relationship between the prepayment risk of PAC tranches and the prepayment risk associated with the support tranches. If the support tranche has an increased risk at receiving prepayments, should that not then increase the risk that the prepayments will reach the PAC tranche?
Can someone please briefly explain to me why I’m wrong?
Thanks!
That sentence simply means that the greater the certainty of cash flows towards the PAC tranches, the greater the uncertainty of the cash flows towards the Support tranches. The support tranches simply absorb the extention or contraction risk, so the cash flows towards the PAC tranches are smoother and stick to the PSA; hence the “level” of absorption of risk has to be greater, if you want the average life of your PAC tranches to be less volatile.
You’re thinking of it in terms of when prepayments actually happen, which is not the context of the statement you posted.
All they are simply saying is that, to take away the prepayment risk of one tranche, you have to give it to another tranche. So if you are removing prepayment risk from tranche A by giving it to the support tranche, then they are inversely related.
Thank you both for the help, it makes sense.