PAC bond

[kasoker]

hi david

i womder if u can elaborate on the PAC bonds - how they work and what is the bands, PSA ect..

i saw a question on that in the 2007 exam and i am not shure i know how to approach it

thanks

 

[David Harper CFA FRM]

ktm:

Apologies, but I won't have time to go into detail on PAC bonds before the upcoming exam (I have added to the list of concepts we need to better illustrate, and we can add an XLS ).

Here is from the FRM handbook: "Prepayment risk can be minimized further by creating a planned amortization class (PAC). All prepayment risk is then transferred to other bonds in the CMO structure, called support bonds. PAC bonds offer a fixed redemption schedule as long as prepayments on the collateral stay within a specific PSA range, say 100 to 250 PSA, called the PAC collar.When the structure is set up, the principal payment is set at the minimum payment of these two extreme values for every month of its life. Over time, this ensures a more stable pattern of payments."

... conceptually, i view them as a type of structured finance (i.e., issuance of notes to investors in tranches) but where the CMO designs the cash flow (waterfall) rules to "protect" the senior (PAC) tranche with target duration and cash flow; achieving this by diverting the uncertainty (prepayment) to the junior tranches

David