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

Question

BlackTom AI · Accepted Answer

The question asks about the primary purpose of creating different CMO tranches (Class A, B, C) from a pool of mortgages.
First, note that the provided data includes the correct answer text but does not supply multiple answer options to evaluate against.
The stated correct option argues that the main aim is to redistribute prepayment risk across different maturity classes, with early tranches absorbing prepayments first and protecting later tranches, thereby attracting different investor clienteles.
To unpack this, CMOs are structured to slice a mortgage-backed pool into tranches with varying risk, timing, and exposure to prepayment. Prepayments shorten the effective life of higher-risk tranches; by layering tranches, the issuer can tailor risk/reward profiles. The senior (often Class A) tranche typically receives priority interest and principal and thus bears less prepayment risk, while junior tranches (Classes B, C) absorb more prepayment risk and offer higher potential yields. This structure helps different investors select tranches aligned with their risk tolerance, liquidity needs, and investment horizons.
Now, regarding the idea of why this option is correct: it correctly identifies prepayment risk redistribution as the core motive, which is central to how CMOs are designed. It also accurately describes the sequencing where early tranches face prepayments sooner, potentially protecting later tranches, and the goal of appealing to a variety of investor types by offering different risk/return profiles.
If there were other options, typical incorrect choices might claim things like all tranches have identical risk or that CMOs are only about liquidity, or that prepayment risk is irrelevant. Those would be misleading because they ignore the fundamental purpose of tranche colorization in CMOs and the clearly observed investor demand for tailored risk and duration.
In sum, the described rationale captures the essence of CMO tranche design: distributing prepayment risk across maturity classes to create distinct risk/return profiles that appeal to a range of investors, with the senior tranches generally absorbing less prepayment and the junior tranches absorbing more.

BU.231.710.51.FA25 PoP Quiz - 3 (Week 6)

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

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