P2.T5.107. Planned amortization class (PAC) and IO/PO strips

David Harper CFA FRM

David Harper CFA FRM
Subscriber
AIM: Describe and work through a simple cash flow example for the following: CMOs, both sequential and planned amortization class; Interest only and principal only strips

Questions:

107.1. A mortgage pool has a principal balance of $800 million and the weighted average coupon (WAC) of the mortgages in the pool is 7.2%. A sequential structure collateralized mortgage obligation (CMO) divides the pool into four bonds: Tranche A has $300 million principal, Tranche B has $200 million principal, Tranche C has $175 million principal, and Tranche D has $125 million principal. All principal payments are directed first to Tranche A, until this bond bond is fully amortized, then principal is directed to Tranche B, and so on. (Sequential structuring is also known as time tranching.) All four bonds pay a coupon of 6.0% per annum. In the first month, the coupon paid by the mortgage pool (i.e., principal plus interest) is $5.430 million. The realized prepayment rate is 200% PSA. In the first month, what is the total cash flow received by Tranche A?

a. $1.96 million
b. $2.40 million
c. $3.10 million
d. $4.90 million

107.2. A CMO planned amortization class (PAC) has only two bonds: The PAC band (Tranche A) and the Companion (aka, support) bond. The PAC bank is structured with a band range of 80% PSA to 300% PSA. If we ASSUME that the PSA level remains within the 80% to 300% range, each of the following is true EXCEPT:

a. The Companion band absorbs all prepayment risk and the PAC band absorb none
b. The cash flow profile and life of the PAC band is predictable
c. The life of the Companion bond will be greater than the life of the PAC bond, regardless of whether PSA is 80% or 300%
d. The Companion bond will have stronger (more) negative convexity than the PAC band

107.3. A pass-through mortgage-backed security (MBS) has an effective duration of 12.0 years. The security is structured into two bonds: an interest-only (IO) strip and a principal (PO) strip. Each of the following is true EXCEPT:

a. As the PSA increases (e.g., 100% to 300%), the value of the interest-only (IO) bond will increase
b. As the PSA increases (e.g., 100% to 300%), the value of the principal-only (PO) bond will increase
c. The weighted average sum of the durations of the IO and PO strips must equal the 12.0 duration of the original pass through.
d. The duration of the IO strip is likely to be negative, even substantially negative

Answers:
 
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