CMO Tranches: Planned Amortization Class (PAC) vs. Companion / Support Tranches
An institutional pension fund seeks a Collateralized Mortgage Obligation (CMO) tranche that provides the highest degree of protection against both prepayment risk and extension risk, providing a highly predictable cash flow amortization schedule. Which CMO tranche is most suitable?
Planned Amortization Class (PAC) tranches offer the highest protection against both prepayment and extension risks, supported by companion/support tranches absorbing variance.
Complete Analysis & Legal Rationale
CMO securities divide mortgage cash flows into specialized tranches: (1) Planned Amortization Class (PAC) tranches offer predetermined sinking fund schedules that protect investors against both prepayment risk and extension risk within a defined collar band. Companion (support) tranches absorb the excess prepayments or extensions to protect the PAC; (2) Companion tranches carry high volatility and prepayment risk; (3) Z-tranches receive zero cash flow until earlier tranches are fully retired.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Planned Amortization Class (PAC) tranches offer the highest protection against both prepayment and extension risks, supported by companion/support tranches absorbing variance.
Fails to adhere to suitability standards regarding B.
Fails to adhere to suitability standards regarding C.
Fails to adhere to suitability standards regarding D.
Official Standard: CMO securities divide mortgage cash flows into specialized tranches: (1) Planned Amortization Class (PAC) tranches offer predetermined sinking fund sc