In the secret sauce book I don’t understand the last sentence about accrual bonds. It says “the accrual bond absorbs most of the prepayment risk in a sequential pay structure” Isn’t it the opposite, since the accrual bond is the last to be paid anything?
prepayment risk = extension risk + contraction risk (not just extension risk)
Prepayment risk consists of two parts: extension risk and contraction risk. It doesnt necesasary mean that it will be prepaid earlier and that’s the risk. Me too I was slightly confused at first and that’s the thought that finally came.
These also shorten the average life correct?
Bradleyz Wrote: ------------------------------------------------------- > In the secret sauce book I don’t understand the > last sentence about accrual bonds. It says “the > accrual bond absorbs most of the prepayment risk > in a sequential pay structure” > > Isn’t it the opposite, since the accrual bond is > the last to be paid anything? In sequential pay structure first tranches absorb contraction risk and last tranches absorb extension risk. As the last tranche accrual tranche absorbs most of extension risk.
"These also shorten the average life correct?’ I think so, because the other tranches are not only recieving principal, but also interest before Z-tranche gets paid.
Thats what I was thinking, just making sure, thanks.
I agree with what’s been written here as this was my understanding. But then I did the FI problems from the 2006 CFA exam (in Schweser Volume 7). It says the accrual tranche has no effect on prepayment risk. If prepayment risk = contraction risk + extension risk, then I don’t see how this can be the case, because it would appear it reduces extension risk of the other tranches. Q74 on pg 46. Can anyone make sense of this?
It just distributes the prepayment risk differently, I think.
I asked the same thing this morning. It is wrong in the sauce.
wait, nerdattax brought up a good point prepayment risk = cont risk + ext risk in a squential pay, the accrual tranch has the highest extention risk and the senior tranch has the highest contracgtion risk how can 74 be C is CFAI contradicting itself?
Thanks - I guess that makes me feel a little better. It seemed to make sense though. If Z tranche doesn’t receive interest or principal payments and others do, it would seem to be absorbing some extension risk. i.e. it is foregoing interest payments that are going toward the other tranches.
can u confirm this?
The part about the interest is definitely true (see pg 109 in Schweser). The only thing I can think of is this: The only thing the Z tranche is giving up compared to other tranches is the interest. If that is the case, then it is not doing anything to help absorb slow or fast prepayments. It is merely the last in line, and no different from the last tranche in line for another sequential pay CMO. Thats a shot in the dark, but thats all I can come up with on it.
Good question! my understanding for the whole CMO, prepayment risk keeps the same. Z-bond wont change the prepayment risk. but CMO re-distributes the risk among tranches. The z-bond assumes most of extension risk??
I hate this section but what i understood from the CFAI text is as follows: Support tranches affect the prepayment risk because they absorb the effect of scheduled payments being eitherr slower or faster. Z Tranches on the other hand do not have any scheduled payments till maturity, so they cannot be used to absorb the pre-payment risk from the other tranches. They are conceptually similar to a zero coupon bond and hence do not have a pre-payment risk. Purpose of Z-Tranche is to attract investors that are worried about re-investment risk.