I got very confused by the answer of this question, can anyone help please ?
The tranches in collateralized mortgage obligation (CMO) that are most likely to provide protection for investors against both extension and contraction risk are:
A. Planned amortization class (PAC) tranches
B. Support tranches
C. Sequential-pay tranches
Answer : A.
Explaination from official curriculum : PAC tranches have limited but not complete protection against both extention risk and contraction risk. This protection is provided by the support tranches.
So, why the answer is NOT B then ? Am i retarded or what ?
The PAC tranche gives its risk to the support tranche, so the support tranche has (roughly) twice the extension risk and (roughly) twice the contraction risk of a normal (sequential-pay) tranche.
That’s why PAC tranches have very low coupon rates and support tranches have very high coupon rates.
The question is undecidable based solely on the information given.
Yeah as s2000 explains, the support tranches take the risk on the chin, protecting the PAC tranche. They are the protective vest. Not a perfectly protective vest but they can take some shelling before the PAC tranche takes damage.
Thanks magician! I totally agree with you…i was just misunderstanding the question, we are looking for protection tranche for INVESTOR not for PAC…I guess i truly am a retarded lol