SIE practice questionhardCMOs — Collateralized Mortgage Obligations
What is the primary purpose of creating tranches in a Collateralized Mortgage Obligation (CMO)?
- ATo guarantee a fixed rate of return regardless of interest rate changes
- BTo eliminate all prepayment risk for every investor
- CTo redistribute prepayment risk among different classes of bondholders based on their risk tolerance✓ Correct answer
- DTo make mortgage investments tax-exempt
Explanation
Why C — To redistribute prepayment risk among different classes of bondholders based on their risk tolerance
CMOs divide a pool of mortgages into tranches (classes) to redistribute — not eliminate — prepayment risk. Different tranches absorb prepayments in a specified order, allowing investors to choose a tranche that matches their risk tolerance and time horizon. CMOs do NOT eliminate prepayment risk entirely (A), guarantee returns (C), or provide tax-exempt status (D).
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