The first tranche that is being paid out with principal payments is protected from extension risk, whereas the rest of the tranches are protected from contraction risk. My question is HOW and WHY? Is it because the first tranche is getting all the principal payments it want (according to schedule with no prepayment risk?)
The short tranche is going to be protected from extension risk because it is going to be paid off first. The longer tranches are going to be better protected from contraction risk, because if prepayments were to increase, the earlier tranches would be paid off first.
any payment (regular + prepayment) would go to the first tranche. So it will get paid off faster. Likely to contract. Will never extend. Depending on how big the tranche is - other tranches will have to wait to get their scheduled principal payments. So they are unlikely to contract.
Excellent reply from cpk123. Thanks