CFA Level II ExamFixed IncomeEasy
A portfolio manager is analyzing a structured finance product backed by a pool of residential mortgages. The product has several tranches, with varying levels of seniority. The manager is particularly interested in a tranche that offers enhanced protection against prepayment risk but, in exchange, bears a higher proportion of extension risk. Which type of tranche is the manager most likely evaluating?
- APlanned Amortization Class (PAC) tranche
- BSequential pay tranche
- CSupport tranche
- DFloating-rate tranche
Show answer & explanationAnswer & explanation
Correct answer: A. Planned Amortization Class (PAC) tranche
A Planned Amortization Class (PAC) tranche is designed to provide a predictable cash flow schedule within a defined prepayment collar, offering protection against both contraction and extension risk within those limits. However, it achieves this stability by shifting excess prepayment and extension risk to support tranches.
Why the other options are wrong
- B. Sequential pay tranches pay principal in order, offering less specific protection against prepayment or extension risk compared to PACs.
- C. Support tranches absorb the prepayment and extension risk from PAC tranches, making them more volatile.
- D. Floating-rate tranches refer to the coupon structure, not their prepayment or extension risk profile.
Planned Amortization Class (PAC) Tranche
A tranche in a structured finance product, particularly CMOs, designed to have a stable and predictable cash flow schedule within a defined prepayment collar, achieved by redirecting prepayment and extension risk to support tranches.
- Offers protection against both contraction (prepayment) and extension risk within its collar.
- Achieves stability by shifting excess prepayment/extension risk to companion or support tranches.
- Has a more predictable average life and cash flow compared to other tranches.
Memory trick: PACs Protect Against Chaos, but Support takes the Strain.