Series 7 practice questionhardCMOs — PAC Bonds
Planned Amortization Class (PAC) bonds within a CMO structure offer investors:
- AA more predictable cash flow pattern by establishing a range of prepayment speeds✓ Correct answer
- BThe highest yield among all CMO tranches
- CGuaranteed returns regardless of interest rate changes
- DProtection against credit risk but not prepayment risk
Explanation
Why A — A more predictable cash flow pattern by establishing a range of prepayment speeds
PAC bonds are designed to provide more predictable and stable cash flows by establishing a band of prepayment speeds (the PAC collar) within which the scheduled principal payments remain constant. This predictability is achieved by directing excess or insufficient prepayments to companion (support) tranches, which absorb the prepayment variability. PAC bonds offer lower yields than companion tranches because of their reduced prepayment risk.
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