Page 74 - FINAL CFA SLIDES DECEMBER 2018 DAY 14
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Session Unit 15:
Sequential Pay CMO, p.83 53. Introduction To Asset-Backed Securities
Separating the cash flows into tranches that are retired;
• Consider a simple CMO with two tranches. Both tranches receive interest at a specified
coupon rate, but all principal payments (both scheduled payments and prepayments) are paid
to Tranche 1 (the short tranche) until its principal is paid off. Principal payments then flow to
Tranche 2 until its principal is paid off.
Contraction and extension risk still exist with this structure, but they have been redistributed
to some extent between the two tranches. The short tranche, which matures first, offers
tanties
investors relatively more protection against extension risk. The other tranche provides
relatively more protection against contraction risk.
Consider the simplified CMO structure presented in Figure 3. Payments to the two sequential-pay
tranches are made first to Tranche A and then to Tranche B:
