PAK Flash Cards
Quantitative Finance and Investment Core (QFIC) Exam
Fall 2015 Edition
ALM
Options
Black-Scholes
Derivatives
Asset Allocation
Interest Rate Models
Investment Policy Statement
Quantitative Finance
Mortgage-Backed Securities
Portfolio Management
Fixed Income Securities
Time Series
Indexing
Bonds
Equity
Tranche Types in
CMOs
(Part 1)
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
1
 Sequential
 PAC
 PAC 2
 TAC
 PACquential
 Z Bond
 VADM
 Floater
 Inverse Floater
 IO and PO
 Exotics
QFI Core Fall 2015
© 2015 PAK Study Manual
2
Investor’s Goals and
Constraints in Investing in
CMO
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
3
1. Minimum yield level
2. OAS or “OAS vs. collateral”
requirement
3. Liquidity requirement
4. Additional funding requirement
5. Bank regulation requirement
6. Dollar price limit
QFI Core Fall 2015
© 2015 PAK Study Manual
4
Agency vs Non-Agency CMOs
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
5
Agency CMOs
They tend to be simpler because of established prepayment models and no
credit risk.
Collateral information tends to be slightly better.
They are structured by dealers, who take all the risk on the deal.
Nonagency CMOs
They tend to be more complex.
The loans backing these nonagency CMOs do not trade lockstep with agency
collateral.
Nonagency CMOs are created from collateral that is nonconforming for the
GSEs.
The investor is taking prepayment and credit risks: the jumbo loans backing
the nonagency CMOs are perceived to have prepayment characteristics.
QFI Core Fall 2015
© 2015 PAK Study Manual
6
Non-Agency CMOs Issues:
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
7
Compensating interest:
In a nonagency CMO deal, prepayments received before the end of the month
result in an interest shortfall for the deal.
Servicer and Bankruptcy Risk:
There can be residual servicing risk if the servicer has financial problems.
Jumbo Prepayments:
Jumbo mortgage prepayments tend to behave differently than agency
mortgage prepayments primarily because the larger loan size of the jumbos
makes refinancing more economical even for smaller interest-rate incentives.
QFI Core Fall 2015
© 2015 PAK Study Manual
8
Investors Types and Behavior
PART I
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
9
Banks
They focus on shorter duration CMOs, since they tend to have shorter term duration as
well. They tend to prefer sequentials over PAC bonds.
GSEs
They will buy and hedge almost any CMO as long as it is cheap.
Insurance Companies
They buy CMOs across the spectrum of “regular” tranches: PACs, sequentials,
PACquentials.
P&C tend to buy shorter maturity tranches.
Life insurance companies are looking for more structure to match against their liabilities
and are more likely to purchase longer duration bonds.
QFI Core Fall 2015
© 2015 PAK Study Manual
10
Investors Types and Behavior
PART II
(HFIS Ch.26)
QFI Core Fall 2015
© 2015 PAK Study Manual
11
Money Managers
They take long-term views about strategy in mortgages. They get better convexity by buying PAC
bonds or give up convexity by buying companion bonds or certain types of sequentials or broken
PACs.
Pension Funds
ERISA and investor considerations keep them from investing in mortgages derivatives. Similar to life
insurance companies, they can be interested in longer duration tranches.
Hedge Funds
They operate in a manner similar to money managers, but could also enter into more complex
trades involving OTC derivatives.
Certain hedge funds specialize in mortgage derivatives: Inverse floaters, IOs, POs, inverse IOs,…
Retail Investors/Regional Dealers
Many CMOs end up in the hands of regional dealers, who in turn sell to retail clients.
Retail clients are yield focus investors. Companion bonds are sold via this channel.
QFI Core Fall 2015
© 2015 PAK Study Manual
12