Series 7 Exam Question 343: Answer and Explanation

Question: 343

For investors interested in purchasing CMOs, which of the following tranches is considered the safest?

• A. Planned amortization class
• B. Targeted amortization class
• C. Companion
• D. Z

Correct Answer: A

Explanation:

A. Planned amortization class (PAC) tranches are considered the safest of all tranches because a large portion of the prepayment and extension risk is absorbed by a companion tranche. Targeted amortization class (TAC) tranches are considered second in terms of safety because they're subject to additional prepayment and extension risk. Companion tranches are considered risky because the average life of a companion tranche varies greatly as interest rates change. Z tranches are basically zero-coupon tranches and are the most volatile of all tranches because they receive no payments until all the CMO tranches are retired.