Series 7 practice questionhardCMOs — Scenario — Rate Environment
In a rising interest rate environment, which CMO tranche would be MOST negatively affected?
- APAC tranche
- BFirst sequential-pay tranche
- CCompanion tranche✓ Correct answer
- DFloating-rate tranche
Explanation
Why C — Companion tranche
In a rising rate environment, prepayments slow down (extension risk), and the companion tranche bears the brunt of this by receiving less principal than expected, extending its average life significantly. While PAC tranches are protected by the companion tranche absorbing this variability, the companion tranche experiences the most extreme extension risk. Its average life can extend dramatically, and its price declines sharply as it is locked into below-market yields for a longer period.
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