Hi David,
Could you take a look of this question for me? Why is IV correct? In the reading, it says a long period of prepayment will exhaust companion bond and shrink PAC band:
http://books.google.com/books?id=2Rk3A0B4epwC&pg=PA547&lpg=PA547&dq=planned+amortization+class+drift&source=bl&ots=jEn9qS66zN&sig=Yqvg3nLqI_ska5JisKnSiiaabkI&hl=zh-CN&ei=uaznSvfUMNOk8Aamp-CZBw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CAgQ6AEwAA#v=onepage&q=planned amortization class drift&f=false
Thanks.
A portfolio manager is considering adding a planned amortization class (PAC) mortgage
derivative to his portfolio with the prepayment PAC bands set at 50% PSA and 250%
PSA . Which of the following is true?
I. Prepayment uncertainty is limited and transferred to the PAC’s companion
bonds providing a lower exposure to prepayment risk
II. The PAC’s prepayment option is analogous to a put option as it offers
protection to investors
III. The PAC is priced at the same spread to Treasuries as its companion bonds
IV. Because the prepayment bands are set so far apart, if prepayments over a
long period are outside the bands there will be no noticeable effect on the
CMO or its companion bonds
a. I and III
b. I and IV
c. II, III and IV
d. II and III
CORRECT: B
Option (I) is correct in that PAC’s provide the benefit of a steady expected stream of
payments and their companion bonds absorb the risk of prepayment outside the bands,
and option (IV) is correct in that a “drift” effect on the bands will take place if the
prepayment rate is outside the band over a long period of time. How far apart the bands
are set is irrelevant to this concept. The drift arises due to the interaction between the
actual cash prepayments and the bands and the changes in collateral balance and the
ratio between the PAC and companion nominal values.
Could you take a look of this question for me? Why is IV correct? In the reading, it says a long period of prepayment will exhaust companion bond and shrink PAC band:
http://books.google.com/books?id=2Rk3A0B4epwC&pg=PA547&lpg=PA547&dq=planned+amortization+class+drift&source=bl&ots=jEn9qS66zN&sig=Yqvg3nLqI_ska5JisKnSiiaabkI&hl=zh-CN&ei=uaznSvfUMNOk8Aamp-CZBw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CAgQ6AEwAA#v=onepage&q=planned amortization class drift&f=false
Thanks.
A portfolio manager is considering adding a planned amortization class (PAC) mortgage
derivative to his portfolio with the prepayment PAC bands set at 50% PSA and 250%
PSA . Which of the following is true?
I. Prepayment uncertainty is limited and transferred to the PAC’s companion
bonds providing a lower exposure to prepayment risk
II. The PAC’s prepayment option is analogous to a put option as it offers
protection to investors
III. The PAC is priced at the same spread to Treasuries as its companion bonds
IV. Because the prepayment bands are set so far apart, if prepayments over a
long period are outside the bands there will be no noticeable effect on the
CMO or its companion bonds
a. I and III
b. I and IV
c. II, III and IV
d. II and III
CORRECT: B
Option (I) is correct in that PAC’s provide the benefit of a steady expected stream of
payments and their companion bonds absorb the risk of prepayment outside the bands,
and option (IV) is correct in that a “drift” effect on the bands will take place if the
prepayment rate is outside the band over a long period of time. How far apart the bands
are set is irrelevant to this concept. The drift arises due to the interaction between the
actual cash prepayments and the bands and the changes in collateral balance and the
ratio between the PAC and companion nominal values.
