CFA Practice Question

There are 490 practice questions for this study session.

CFA Practice Question

Which of the following statements is (are) true with respect to the characteristics of asset-backed securities (ABS)?

I. Prepayment assumptions are more critical in valuing amortizing loans than non-amortizing loans.
II. The lower the excess servicing spread, the greater the credit enhancement to the ABSs.
III. Generally, when an external party acts as guarantor of an ABS, the credit rating of the ABS becomes more tied to the guarantor's credibility than to the underlying assets backing the ABS.
IV. When structuring an ABS in the form of a senior-subordinate tranche, most of the prepayments will go to the subordinated tranche in order to reduce reinvestment rate risk to the senior tranche unit holders.
A. I and III
B. I and IV
C. II and III
Explanation: I is true. Prepayment assumptions are more critical in valuing amortizing loans than non-amortizing loans because for non-amortizing loans (e.g., credit card loans) there is no schedule for planned principal repayments; it would be even more ineffective to project a prepayment schedule.

II is incorrect. The excess servicing spread is the difference between what the pool generates and what the ABS investors and financial intermediary receive. This spread is used as a reserve to substitute for any losses that may arise inside the pool. The wider the excess servicing spread, the greater the credit enhancement to the ABSs.

IV is incorrect. A senior-subordinate structure is not set up to counter reinvestment rate risk but, rather, to reduce credit risk to the senior tranche investors. Consequently, most prepayments are directed towards the senior tranches so that they may collect their initial investment first.

User Contributed Comments 2

User Comment
danlan2 IV: junior branch is not the same as support branch
dblueroom Agreed. It's like a sequential pay structure.
You need to log in first to add your comment.