FI hw 7 - Siming Zhu AEM 4260 Fixed Income November 4, 2008...

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Siming Zhu AEM 4260 – Fixed Income November 4, 2008 Homework # 7 [Ch 12] Question 3. a . By creating a CMO, an issuer eliminates the prepayment risk associated with the underlying mortgages. Do you agree with this statement? b. Wall Street often refers to CMOs as “customized securities”. Explain why. a. I disagree with the statement. CMOs are bonds created by redirecting the cash flows of mortgage related products so as to minimize prepayment risk. However, simply creating a CMO cannot eliminate prepayment risk. It can only transfer the different forms of prepayment risk among different classes of bondholders. b. Wall Street often refers to CMOs as “customized securities” because they can be modified to meet the needs and expectations of specific investors. The tranches of CMOs have average lives that are both shorter and longer than the collateral, thus attracting investors who have a preference for an average life different from that of the collateral. Furthermore, by prioritizing the distribution of principal, CMOs offers shorter-term tranches protection from extension risk and longer-term tranches protection against contraction risk. Thus, CMOs offers an investment that suits each individual’s preferences for maturity and risk. Question 14 Suppose that $1 billion of pass-throughs is used to create a CMO structure with a PAC bond with a par value of $700 million and a support bond with a par value of $300 million. a. Which of the following will have the greatest average life variability: (i) the collateral, (ii) the PAC bond, or (iii) the support bond? Why? b. Which of the following will have the least average life variability:
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This note was uploaded on 01/20/2009 for the course AEM 4260 taught by Professor Bogan,v. during the Fall '06 term at Cornell.

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FI hw 7 - Siming Zhu AEM 4260 Fixed Income November 4, 2008...

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