Reading 56 CFAI Q 29 part C.

For those not willing to open the book, i’ll try a brief summary…SO we have 2 different CMO structures with a sequence of PAC tranches A-E. In both structures, PAC tranches A-E are identical, both have the same par amount and coupon. The difference is that structure I has a tranche F which is a $500M par support tranche. In structure 2, in replace of of the $500M support tranche, there is a $200M PAC II tranche and then a $300M support tranche (Tranche G). What is the difference in the average life variability of tranche G in stucture II and tranche F in structure I? My line of thought was that since the $500 million support tranche (tranche F) could withstand more prepayments, it would have the potential for a longer life, thus giving it a longer average life variability. My thinking is obviously flawed since the answer says that tranche G has “greater life variability because it must provide prepayment protection in Structure II for not only the PACs but also the PAC II tranche.” Would someone mind taking a stab at this…

i think that your thinking is fine… the answer and yours say pretty much the same thing- you’re just looking at it in 2 different ways. the top one- there’s the one bigger 500 mil support tranche. the second structure they break that out into the PAC 2 tranche and then the support tranche. the support tranche just like you say in the 2nd one is smaller, so if there are prepayments, it’s going to take them and have “greater life variability” because it’s life might be shortened quite a bit since it’s now only 300 mil big and not 500 mil big. once on the bottom one the support tranche gets eaten up, you then move into the PAC 2 tranche… so for the PAC 1 guys, i’d think both still offer the same protection to them. the bottom one just breaks out that 500 mil lump into another tranche- you could get a little less interest being in that 200 mil tranche in exchange for a little bit more protection.

Another way to rephrase the question is: which trenche would experience the highest volatility due to prepayments? The answer is Tranche G since it has to support all the senior tranches above.