Series 7 practice questionmediumCMOs — Tranches
In a collateralized mortgage obligation (CMO), mortgage payments are divided into tranches. Which statement BEST describes how tranches work?
- AAll tranches receive equal principal payments simultaneously
- BTranches receive principal payments sequentially, with the first tranche receiving all principal until retired before the next tranche begins receiving principal✓ Correct answer
- COnly the last tranche receives principal payments
- DTranches receive only interest payments, never principal
Explanation
Why B — Tranches receive principal payments sequentially, with the first tranche receiving all principal until retired before the next tranche begins receiving principal
In a sequential-pay CMO structure, principal payments (including prepayments) are directed to the first tranche until it is completely retired. Then principal payments flow to the second tranche, and so on. All tranches receive interest payments simultaneously. This structure creates securities with different expected maturities, allowing investors to choose tranches that match their investment time horizons.
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