I understand that the first tranches soak up the principal repayments and the later tranches gets to enjoy receiving the interest. Thus distribution of contraction risk. But there is this Ztranche that supposedly does not receive any interest payments at all. The schweser book isn’t very clear on what this Ztranche does really. Can someone give me a quick tutorial on it?
The Z-tranche is better protected against contraction risk. While the senior tranches are better protected against expansion risk.
but if they don’t receive interest…what is the point of not having contraction risk and having a longer life?
The same reason why there are zero-coupon bonds. Some investors don’t want to deal with reinvestment risk.
the interest supposed to be paid to the z-tranche is distributed to the other tranches - and the z-tranches principal grows by the amount of interest paid to the other tranches. So it gets a longer life - but at the end of its life will receive more payments as well.
i think the ztranche may be compensated with a higher return for its troubles
Is Z-tranche accural tranche?
yep
ah ic thanks. so it is “storing” up its interest payments in the form of a higher principal repayment later? z tranche = accrual tranch kevin.
Thank you, CP and Kelly need to review Fixed income tomorrow
Z-tranche still get paid. It’s just get paid at the very end. So if the investors anticipate the interest rate will be low for a while, they could invest into Z-tranche, enjoy the protection against contraction risk and receive the payment when investment opportunities are better. That’s the theme of CMO’s: they simply redistribute the expansion and contraction risk, so that the loans can be repackaged to better suit the needs of different investors.
they get huge interest rates to make up for the risk involved. Most of this was bought by hedge funds that used other investments to “hedge” the risk (like CDS). After a while they didnt really have room for any more of this debt and the CMBS/CDO markets started to suffer. As many hedge funds went under over the last year, this problem has only been exacerbated.
in regard to the z (accrual) tranche, has anyone had an issue with book 6 exam 2 morning session question 50? the support tranche has high extension risk and low contraction risk while the PAC 1 tranche has low extension and high contraction risk… so isnt statement 1 correct? Schweser explanation: Statement 1 is incorrect. The PAC I tranche has less extension risk and less contraction risk than the support tranche. It has less contraction risk because when rates fall and prepayment speeds increase, the average life of the PAC I tranche falls by less than the average life of the support tranche. It has less extension risk because when rates rise and prepayment speeds fall, the average life of the PAC I tranche increases by less than the support tranche’s average life. apologies if this was covered already but i tried running a search for this but couldnt find it