A Collateralized Mortgage Obligation (CMO) addresses prepayment risk by:

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Question context: A Collateralized Mortgage Obligation (CMO) addresses prepayment risk by:

Option 1: Creating multiple tranches with different priorities for receiving prepayments, redis- tributing risk among investors
- This is the core mechanism of a CMO. By structuring cash flows into strata (tranches) with varying seniority, different investors bear different levels of prepayment risk. Prepayments accelerate some tranches and delay others, effectively redistributing the risk rather than leaving it all with a single investor.

Option 2: Eliminating prepayment risk entirely through credit default swap protection
- Prepayment risk is tied to borrower behavior and interest rate dynamics, not credit default risk. Credit default swaps protect against default risk, not prepayment behavior. Therefore, this option does not address prepayment risk in CMOs and is inaccurate in this context.

Option 3: Requiring all underlying borrowers to pay prepayment penalties if they refinance
- In practice, borrowers may face various penalties or none at all, and there is no universal requirement that all borrowers pay prepayment penalties. Even when penalties exist, they are not a mechanism used in CMOs to manage prepayment risk; prepayment behavior is still uncertain and penalties are not a guaranteed tool for risk transfer across tranches.

Option 4: Completely eliminating prepayment risk through contractual prepayment penalties
- No contractual penalty can guarantee the elimination of prepayment risk. Prepayment risk stems from market conditions and borrower decisions, and while penalties might slow prepayments in some cases, they cannot fully eliminate the risk. This makes the statement inaccurate.

In summary, the mechanism that addresses and redistributes prepayment risk within a CMO is the use of multiple tranches with different priorities for receiving prepayments, thereby allocating risk among investors rather than removing it entirely.

BU.231.710.51.FA25 The Final Exam

A Collateralized Mortgage Obligation (CMO) addresses prepayment risk by:

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