CFA Practice Question

CFA Practice Question

Which of the following securities is commonly associated with the word "tranches"?
A. Collateralized mortgage obligation
B. Mortgage passthrough certificate
C. Structured notes
Explanation: The answer called for in this questions is "collateralized mortgage obligation." Collateralized mortgage obligations are amortizing debt securities that represent an interest in a pool of mortgages. Unlike mortgage pass-through certificates (pass-throughs), collateralized mortgage obligations are amortized according to a specific schedule. Whereas the principal of a mortgage pass-through certificate is paid periodically and equally to all holders, the principal of a CMO is paid asymmetrically. Specifically, CMOs are issued in a series of classes, each of which represent a differing degree of seniority in regard to principal payments. These classes are referred to as "tranches." To illustrate the concept of tranches, consider the following example:

A CMO is issued with a series of four tranches: tranche A, tranche B, tranche C, and tranche D. The principal payments are initially allocated toward tranche D and continue exclusively to this tranche until it is completely exhausted. The principal payments then begin to allocate toward tranche C, until this tranche is paid off. This process continues until the principal of the entire issue (tranches A through D) has been exhausted. As you can see, a CMO exposes certain investors to less prepayment risk than a pass-through certificate.

User Contributed Comments 6

User Comment
surob good and complete explanation. I wish most of the explanations were like this, althought it might sound redundant to someone, but might benefit another. just a thought.
sagania Great explanation, finally I understand how the CMOs work.
Andy552 Anyone know why C is highest quality, would have thought A is highest quality, as with bonds grading.
dwalasinski The naming and order of trances is at the discretion of the issuer. I wouldn't take "highest letter first" for granted.
mbuenafe structured notes also have tranches... albeit they have embedded options. I don't want to confuse anyone but I worked in securitization FO for 4.5 years and you can issue a structured note with a senior tranche, mezzanine tranche and then a subordinate tranche; A1, A2 and B tranches. The issuer has the right to call the bonds when the pool hits 10%.

In terms of answering this question yes A is the most correct answer.
gyee2012 mbuenafe^ I commend you for your expert knowledge
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