CFA Practice Question

There are 764 practice questions for this topic.

CFA Practice Question

If the manager of a savings & loan association portfolio is concerned about extension risk and wants to invest in the CMO market, he should choose a (an) ______.
A. I/O
B. Fannie Mae passthrough security with a WAM of 300 months
C. PAC tranche of a Fannie Mae CMO issue with an average life of two years
Explanation: The manager is concerned with extension risk and should seek a shorter term, safer investment.

User Contributed Comments 8

User Comment
brandsat why not I/O ?
noonah brandsat, I think because IO's can go either way when extension happens.
dblueroom Noonah I dont think that's the reason. When interest rate rises, IO investors receive more interests, which increases the value of the IO. I think IO is just risky investment, not suitable for this particular manager. anyone else?
dblueroom actually this is why - cash flows expected from IO is uncertain, because IO's cash flows depends on the underlying principal balance. So if the entire remaining balance on the principal were paid off, the IOs would no longer generate any cash flows.
ljamieson PAC is the safer investment for short term.
tim2 I guess that's assuming the investor is investing for less than 2 years
ilgibe I/O is more exposed to extension risk than the Fannie Mae CMO: if prepayments are less than expected, I/O may be outstanding for more time without increasing too much in value (negative convexity).
hks101 If you invest in I/O, you want extension. More extension, more CF, more value.
You need to log in first to add your comment.