Study Question of the Week: March 7, 2013 Edition

This week’s study question from the Solomon Online Exam Simulator question database is now available. Relevant to the Series 6, Series 7, Series 62, Series 79, and Series 82. –ANSWER POSTED– Continue reading

This week’s study question from the Solomon Online Exam Simulator question database is now available.

Question (Relevant to the Series 6, Series 7Series 62Series 79, and Series 82):

Which of the following are not true of CMOs?

Answers:

a. CMOs tend to be more sensitive to interest rates than most fixed income securities

b. Most CMOs protect against both prepayment risk and extension risk

c. A decrease in interest rates may lead to CMO investors getting their principal payments sooner than expected

d. CMOs can be issued as a government agency CMO or as a private-label CMO

Correct Answer: B

Rationale: A sequential pay CMO is the most basic of CMO structures, also known as a plain vanilla offering. Each tranche receives regular interest payments, but principal payments are made to the first tranche alone until it is completely retired, after which principal payments are applied to the next tranche until it is fully retired, and so on until the last tranche is retired in sequence. While most CMOs protect against prepayment risk better than a traditional mortgage backed security, they are still subject to prepayment risk and extension risk. CMOs are also more sensitive to interest rate changes than other fixed income securities because when interest rates fall, prepayment speeds usually accelerate, and CMO investors may receive their principal back sooner than they expected. They then have to reinvest this principal at lower interest rates.

Weekly study questions are from Solomon’s industry-leading Online Exam Simulator.

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