A pension fund manager is evaluating an investment in a planned amortization class (PAC) tranche of a collateralized mortgage obligation (CMO). The manager is concerned about the prepayment risk associated with mortgage-backed securities. Which of the following statements most accurately describes the prepayment risk characteristics of a PAC tranche?
- APAC tranches provide protection against contraction risk but are fully exposed to extension risk.
- BPAC tranches absorb all excess prepayments, leaving support tranches unaffected.
- CPAC tranches offer protection against both extension risk and contraction risk within a specified prepayment range.
- DPAC tranches are highly sensitive to rising interest rates, leading to significant extension risk.
Show answer & explanationAnswer & explanation
Correct answer: C. PAC tranches offer protection against both extension risk and contraction risk within a specified prepayment range.
PAC tranches are designed to provide a more stable and predictable stream of cash flows by having a principal repayment schedule that is protected against both faster-than-expected (contraction risk) and slower-than-expected (extension risk) prepayments, as long as prepayments remain within a specified collar or band. This protection is achieved by shifting prepayment risk to companion or support tranches.
Why the other options are wrong
- A. PAC tranches protect against both contraction and extension risk within their defined prepayment band, not just contraction risk.
- B. PAC tranches do not absorb all excess prepayments; rather, excess prepayments are absorbed by the support tranches, which protect the PAC tranches.
- D. PAC tranches are specifically designed to reduce sensitivity to interest rate changes (and thus prepayment speeds) within their collar, reducing both extension and contraction risk.
PAC Tranche Prepayment Risk
Planned Amortization Class (PAC) tranches in CMOs are designed to have a more predictable cash flow stream by reducing exposure to both contraction and extension prepayment risk within a specified prepayment range.
- Protected by companion/support tranches.
- Offers stability within a prepayment collar.
- Lower prepayment risk than plain-vanilla MBS.
Memory trick: PACs are like a shielded car, within a speed limit.