Page 73 - FINAL CFA SLIDES DECEMBER 2018 DAY 14

LOS 53.f: Define prepayment risk and Session Unit 15:

describe the prepayment risk of mortgage-
53. Introduction To Asset-Backed Securities
backed securities., p.80

Collateralized Mortgage Obligations, p.82

CMOs are securities that are collateralized by RMBS; each CMO has multiple bond classes (CMO tranches),
partitioned to have different exposures to prepayment risk (total prepayment risk of the underlying RMBS

is not changed); it is simply reapportioned among the various CMO tranches.

Institutional investors have different tolerances for prepayment risk; some concerned with extension risk
while others may want to minimize exposure to contraction risk. It is also possible to ensure each CMO
tanties
tranche has a different mixture of contraction and extension risk, hence more closely match to the unique
asset/liability needs of institutional investors and investment managers. This increases the potential
market for securitized mortgages and reduces funding costs.

Primary CMO structures include:
• Sequential-pay tranches,
• Planned amortization class tranches (PACs),
• Support tranches, and
• Floating-rate tranches.