This week’s study question from the Solomon Online Exam Simulator question database is now available.
Question (Relevant to the Series 6, Series 7, Series 62, Series 65, Series 79, and Series 82):
CMOs were primarily created to distribute the amount of ___________________ risk to investors with various risk tolerances. Choose the BEST answer.
Answers:
A. default
B. credit
C. prepayment
D. interest rate
Correct Answer: C. prepayment
Rationale: Unlike a traditional mortgage backed security that has a single coupon rate and maturity date, a collateralized mortgage obligation is a pool of mortgage-backed securities and/or individual mortgages which is structured into several classes of bondholder, each with a different interest rate and term. With a CMO, streams of interest and principal payments are sliced up and distributed to different classes of investors in separate tranches (slices, in French). CMOs were first introduced in 1983 to offer MBS investors a greater variety of maturities and certainty of cash flow. By redistributing prepayment risk away from some tranches and toward others, CMOs allow investors to choose how much of this type of risk they are willing to accept over a given time horizon. Tranches with the lowest exposure to prepayments offer lower yields to investors wanting to reduce their risk exposure. Tranches that accept higher prepayment risks attract investors seeking higher yields.
Weekly study questions are from Solomon’s industry-leading Online Exam Simulator.