Question22 Jack, a trader in an investment bank is betting that interest rates will fall in the short term. Investing in which of the following securities issued from a pool of mortgage loans will offer the HIGHEST speculative benefit to the bank? Select one alternative: a. The pass-through securities b. The most senior tranche (tranche A) in a CMO c. Mortgage-backed bonds d. IO strip in a CMO e. PO strip in a CMO ResetMaximum marks: 2 Flag question undefined

Question

Question22 Jack, a trader in an investment bank is betting that interest rates will fall in the short term. Investing in which of the following securities issued from a  pool of mortgage loans will offer the HIGHEST speculative benefit to the bank? Select one alternative: a. The pass-through securities b. The most senior tranche (tranche A) in a CMO c. Mortgage-backed bonds d. IO strip in a CMO e. PO strip in a CMO ResetMaximum marks: 2 Flag question undefined

BlackTom AI · Accepted Answer

The question asks which security from a pool of mortgage loans would offer the highest speculative benefit to the bank if interest rates are expected to fall in the short term. We’ll examine each option in turn and connect it to how falling rates affect its value.

Option a: The pass-through securities. Pass-throughs pass along both principal and interest payments to investors pro rata. When rates fall, prepayment speeds typically increase, which can shorten the duration of pass-throughs and return principal to investors sooner. While this can be favorable in some strategies, the pass-through is not uniquely leveraged to benefit disproportionately from falling rates; its value increases, but not as strongly as instruments designed to magnify exposure to prepayments and rate movements.

Option b: The most senior tranche (tranche A) in a CMO. The senior tranche is the least exposed to credit risk and prepayment risk; it generally benefits less from rising or falling prepayments because it receives principal later in the sequence and has cushioning against early principal repayments. In a falling-rate scenario, prepayments speed up, which actually tends to hurt senior tranches that rely on longer exposure to accumulate interest. So this is not the instrument that yields the highest speculative payoff from falling rates.

Option c: Mortgage-backed bonds. Mortgage-backed bonds are like generic debt instruments secured by a pool of mortgages. Their sensitivity to prepayment risk and rate changes is present but not specifically leveraged in a way that concentrates upside for a trader betting on falling rates. They don’t inherently maximize payoff from faster prepayments the way stripped securities do.

Option d: IO strip in a CMO. An Interest-Only (IO) strip receives only the interest cash flows from the underlying pool. When interest rates fall and prepayments accelerate, the interest portion paid to IOs typically declines because the pool’s balance shrinks more quickly and the interest payments decrease. Consequently, IO strips tend to lose value as prepayments accelerate, making them poor bets for a decline-in-rates scenario.

Option e: PO strip in a CMO. A Principal-Only (PO) strip receives the principal cash flows from the underlying pool. When rates fall and prepayments speed up, more principal is returned sooner, which directly increases the value of PO strips. This structure magnifies gains from a faster prepayment environment and thus provides the highest speculative benefit for a trader betting on falling rates.

In summary, falling interest rates typically accelerate prepayments, which disproportionately benefits PO strips due to their principal-only cash flow structure, while IO strips usually suffer, and the more senior or general securities don’t offer as strong a leverage to that scenario. Therefore, the correct choice is the PO strip in a CMO.

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Similar Questions

Interest-Only (IO) strips created from mortgage-backed securities:

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

A pass-through mortgage-backed security:

What is the primary purpose of creating different CMO tranches (Class A, B, C) from a pool of mortgages?

A depository institution holds IO strips as a hedge against its regular bond portfolio. The CFO argues this hedge will be effective, but the risk manager expresses concern. Under what market scenario would the IO hedge fail to provide the expected protection?

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