Series 7 practice questionhardCMOs — Companion Tranches
Companion (support) tranches in a CMO structure:
- AHave the most predictable cash flows of any tranche
- BAbsorb the prepayment variability to protect PAC bondholders, resulting in highly unpredictable cash flows✓ Correct answer
- CAre always rated AAA by credit rating agencies
- DReceive only interest payments and no principal
Explanation
Why B — Absorb the prepayment variability to protect PAC bondholders, resulting in highly unpredictable cash flows
Companion tranches (also called support tranches) absorb the excess prepayments when rates fall and receive reduced principal when rates rise, thereby shielding PAC tranches from prepayment variability. This makes companion tranches the most volatile and unpredictable tranches in a CMO, carrying the highest degree of both prepayment risk and extension risk. In exchange, companion tranches typically offer higher yields.
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