Schweser Book 5, Pg 122 Q. Consider a collateralized mortgage obligation (CMO) structure with one planned amortization class (PAC) and one support tranche outstanding. Also, assume that the prepayment speed is higher than the upper collar on the PAC. Which of the following statements is MOST ACCURATE? The: A. PAC tranche has no risk of prepayments B. average life of the support tranche will contract C. average life of the PAC tranche will extend D. average life of the support trance will extend. Clearly it is not choices C or D. I selected B and got it right. However, A is a possibility too in this case… Schweser’s answer The PAC tranche COULD receive higher prepayments if eventually the support tranche is fully repaid its principal. (i.e. a busted PAC). However, the question says that the support tranche is still outstanding, which means this hasn’t happened yet. So…according to THEIR OWN answer…they are saying that choice A is possibly a correct answer - since in the question it mentions that the support tranche is still oustanding…which means CURRENTLY the PAC has no prepayment risk. I feel like this is a badly worded question…Choice A should have read something like “The PAC will never have any prepayment risk” …then this could clearly be eliminated…but the way they have phrased it…I was pondering between A and B for quite a while… thoughts??
No, it still has risk, for instance, if interest rates were to drop by a significant margin tomorrow, prepayment would increase and you might find the PAC tranche receiving prepayments. The general idea is that prepayment risk still exists for PAC tranches in the same sense that bankruptcy risk still exists for AA bonds. Both are unlikely situations, but existantial risk factors nonetheless.
B is the best answer. A is incorrect, prepayment risk will become apparent when the support tranche is gone.
PAC works according to the amortization schedule and Support Tranch adjust itself according to the prepayment schedule of the PAC tranch. So if all of a sudden, Interest rates fall and mortgage owners start prepaying the loans quicker than expected (higher than the PSA collar upper limit), cash inflow to the mortgage pool increases and Support tranch has to ‘soak in’ those excess prepayment just to maintain the avg life variability of the PAC tranches and since Support tranch is getting prepaid at a much faster rate, it’s life is contracted… So B looks right on-the-money option A is just ambiguous wording… Because, if we don’t yet have a broken-PAC, and Interest Rates rise to notoriously high levels, prepayments would be little to none, so the support tranch payments should be halted (extension risk) in order to satisfy the PAC. So yea, we still have Extension risk and yes verbiage like this “The PAC will never have any prepayment risk” would have completely eliminated this option. Hope we get better answer choices than these in the real-deal
Just to clarify, I was agreeing wtih dinesh and maratikus
thank you dinesh…that’s what I meant… I understand that a PAC tranche can have prepayment risk…given the situation that the support tranche is completely amortized. My point was …in this question since they say a support tranche is still outstanding and the wording of A is that the PAC HAS no prepayment risk…makes you wonder…if they are talking about THIS specific point in time…or just generally… like I siad…I chose B when i answered…seemed kinda obvious…but we all know how CFA tries to put in these minute details to trick you into thinking something is a good answer…but you gotta choose the BEST one…