So I know there are two types of risk extension risk (which is when the interest rates rise) and the contraction risk (which is when the interest rates fall). But I dont understand how in a sequential pay CMO, tranche A protects from extension risk and how tranche B protects us from contraction risk. Could someone please explain this in a intuitive manner. Thank you.
First, extension risk is apparent in an increasing rate environment because it is risk the owner of the debt will take longer to pay it off than originally planned. If rates raise, you will lose because you are stuck receiving interest payments at the lower rate. Different tranches get paid off in priority to the others. …so, if you get a tranche of the CMO that gets paid first, the A tranche, then you have just insured that you will get your interest payments as soon as possible… before raise raise too much. The opposite situation exist for contraction risk. In a decreasing rate environment you would rather get paid more slowly. Prepayments will be a disadvantage. In that situation you want the tranche that gets paid last. Choosing the tranche is based on what you think the rate environment will be.
Hmmm. So all the risk protection we were talking about was from the debt holders side, not the customers side ?
yes, from the debholder’s side, because the customer is the one that is likely to default on the terms of the payment which cause either extention or contraction risk.
yea, from the debholder side, because the customer can default on the payment terms, which causes contraction or entension risk.
Most times, there is a penalty for prepayment.
Makes a lot of sense now. Thanks KMeriwetherD and olajideanuoluwa001.