CFA Latest CFA Level 2 Discussions Under what circumstances would the effective collar of PAC tranches widen?

Under what circumstances would the effective collar of PAC tranches widen?

  • This topic has 1 reply, 2 voices, and was last updated Apr-17 by vincentt.
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    • E92M3
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      I understand how the upper and lower bound of the collar can move inward; however, I don’t get how a collar can widen. Let’s say we have an initial collar of 90PSA – 300PSA. Consider what will happen in the rolling situations:
      1) Previous prepayments are well within the 90-300 range – the effective collar should remain roughly the same as the initial collar.
      2) Previous prepayments are close to 90 or lower than 90 – the upper bound (300) moves up as there are plenty of support tranche left to absorb future prepayments. I’m not exactly sure what happens to the lower bound in this case, but I think it should mine up as well since the tranche should have less ability to endure low prepayment rates as it had already experienced them in the past.
      3) Previous prepayments are close to 300 or exceeds 300 – the upper bound moves down as the there the support tranches are being paid off quicker than expected. I’m once again not sure what happens to the lower bound.

      In all three situations above, I do not see a scenario in which the upper bound moves up while the lower bound moves down thereby allowing the effective collar to widen.

      Another thing that, in my opinion, wasn’t addressed adequately in the curriculum is what happens when the prepayments are unexpectedly low. We know that when the prepayments rates are higher than expected, the support tranches absorbs the extra prepayments until they are paid off. But when’s when the prepayments are lower than expected? In this case, where does the money come from to satisfy the PAC tranches? We can’t expect the the support tranches to actually cough up money and earn a negative income can we?

    • vincentt
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      As far as I’m aware, the support tranche absorbs both excessive and insufficient prepayments (that’s definitely in the text). However, i’m not too sure if lower than expected prepayments are considered a problem, unless the PACs are not receiving their full scheduled payment.

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