Wiley - CMO Prepayment Risk Question


Consider the following statements:

  • Statement 1: A pool of mortgage loans serves as collateral for collateralized mortgage obligations (CMOs).
  • Statement 2: In a sequential-pay CMO, the tranche with the longest average life entails the least extension risk.

Which of the following is most likely?

The correct answer is both statements are incorrect. However, the explanation states sequential-pay CMOs have the greatest protection from contraction risk and has the most extension risk.

Is Wiley contradicting itself?

  1. The collateral for CMOs is MBSs.

  2. Longest average life = highest extension risk. This one is so obvious!

Thanks CML. I definitely read the question wrong…obvious now looking at it again.

Not necessarily; it can be a pool of loans.

  1. multiple mortgages pools together so we have a pool of mortgages. then we called it mortgage-backed security(MBS) because the bondholder is secured by a poof of mortgages. to level up the idea of securitization, multiple MBSs pooled together so we have a pool of MBSs then we called it collateralized mortgage obligations(CMO) because now the bondholder of this is backed by a pool of MBSs.
    in CFA curriculum 5.2 of the first paragraph has a well explanation for Statement 1and what a beautiful and confusing innovation :crazy_face:

  2. I don’t know how to answer 2. all I know is that the longer the average life of the tranche I select, it means I want to avoid contraction risk, meaning I’d rather stay as long as in this investment. I’m not concern about extension risk.

Hate it when prep providers ( that too a reputed one) try to reinvent something and force some stupid stuff.

Actually the question is (very) poorly drafted and makes zilch sense. It would confuse the candidates more than helping them

Agree, especially English is not candidate’s native language