Hi, let say you have the following: PAC A PAC B PAC C PAC C PAC D Support S A has the highest contraction risk because of prepayments. What is the exact role of the support S? Does it take any prepayments prior to A,B,C and D and thus reduce the contraction risk of A? Thanks
any suggestions please? working on a question at the moment and got confused…
Support tranche always has the highest ANY risk, including contraction risk.
All PAC tranches will have lower prepayment risk (both contraction and extension) when compared to support tranches. PAC has a defined principal repayment schedule based on the initial collar. Now if the prepayments are less than lower end of the collar the short fall is made by support tranche. So extension risk of PAC goes down but for support increases. If prepayments are higher than upper end of the collar the excess is taken by support so the contraction takes place for support but not for PAC.
Support tranche always has the higheest prepayment and contraction risk. If rates fall, support tranche will take up all the extra prepayment beyond the collar of the PAC leading to higher contraction risk for the support tranche. If rate rise, (leading to less payments below the PAC collar) payments for the support tranche will be diverted to the PAC leadind to higher extension risk for the support tranche. Once the support tranche is fully paid off, trouble then begins for the PAC. The PAC is called a Busted PAC (I like that).
nice name for a rap group @Busted PAC
Remember only the PAC securities are 1st on the capital structure and are protected for contraction risk.
And the accrual/z tranche gets no love until the bitter end (principal or interest).