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1 ANSWERS TO HOMEWORK QUESTIONS - HW #5 Answers for Chapter 12 Questions: 1, 13, 19, 20, & 26 1. How does a CMO alter the cash flow from mortgages so as to shift the prepayment risk across various classes of bondholders? CMOs redirect cash flows from a pass-through to various bond classes making it possible to redistribute prepayment risk for investors who want to reduce their exposure to prepayment risk. Because the total prepayment risk of a pass-through will not be changed by altering the cash flows, other investors must be found who are willing to accept the unwanted prepayment risk. 13. Suppose that a PAC bond is created assuming prepayments speeds of 80 PSA and 350 PSA. If the collateral pays at l00 PSA over its life, what will this PAC tranche's average life be? As illustrated in Exhibit 12-9, the average life for the PAC bond is stable at 7.26 years as long as the PSA speed is between the two designated prepayments speeds (i.e., between the lower and upper collars). However, at slower or faster PSA speeds than the two collar speeds, the schedule is broken with the average life changing. The average life lengthens when the prepayment speed is less than the lower collar and shortens when it is greater than the upper collar. 19. Consider the following CMO structure backed by 8% collateral: Tranche Par Amount (in millions) Coupon Rate (%) A \$300 6.50% B \$250 6.75% C \$200 7.25% D \$250 7.75% Suppose that a client wants a notional IO with a coupon rate of 8%. Calculate the notional amount for this notional IO.

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