US Government Debt

Question 1

A “riskless” security maturing in 52 weeks or less is a:

A. Money market instrument
B. Non-callable funded debt
C. Treasury bill
D. Treasury note

Answer 1

The best answer is C.

The key word is “riskless.” Treasury bills mature in 52 weeks or less and are issued by the U.S. Government, the safest issuer available.

Question 2

All of the following statements are true about Treasury Bills EXCEPT:

A. the U.S. Treasury issues 1 week T- Bills
B. the U.S. Treasury issues 13 week T- Bills
C. the U.S. Treasury issues 26 week T- Bills
D. T-Bills are issued at a discount from par

Answer 2

The best answer is A.

The U.S. Treasury issues 4 week, 13 week, 26 week, and 52 week T-Bills at a discount from par. The Treasury does not issue 1 week T-Bills.

Question 3

The smallest denomination available for Treasury Bills is:

A. $100
B. $1,000
C. $10,000
D. $100,000

Answer 3

The best answer is A.

The minimum denomination on a Treasury Bill is $100 maturity amount. The minimum denomination on Treasury Notes and Bonds is also $100 maturity amount. Note that this is different than the typical minimum $1,000 par amount for other debt issues.

Question 4

Which of the following is an example of a derivative product?

A. collateral trust certificate
B. American depositary receipt
C. collateralized mortgage obligation
D. mutual fund

Answer 4

The best answer is C.

A “derivative” product is one whose value is “derived” via a “formula” from an underlying investment. Options are the most basic derivative - option values are derived from the price movements of the underlying stock, in addition to time premiums on the contracts. Collateralized mortgage obligation values are derived from the underlying mortgage backed pass-through certificates held in trust by recutting the cash flows and applying them to the CMO tranches. Again, these are derived via a formula. Mutual fund shares are not a derivative, because Net Asset Value per share is a direct correlation to the value of total net assets divided by the number of shares outstanding. Collateral trust certificates are directly issued by corporations - these are not derivative investments. Finally, each American Depositary Receipt represents a fixed number of foreign shares held in trust. These are also not a derivative product.

Question 5

All of the following securities would be used as “collateral” for a collateralized mortgage obligation EXCEPT:

A. “Sallie Maes”
B. “Freddie Macs”
C. “Ginnie Maes”
D. “Fannie Maes”

Answer 5

The best answer is A.

Only mortgage backed pass-through certificates are used as the backing for CMOs - and Ginnie Mae (Government National Mortgage Assn.), Fannie Mae (Federal National Mortgage Assn.), and Freddie Mac (Federal Home Loan Mortgage Corp.) all issue pass-throughs. Sallie Mae issues debentures, and uses the funds to make a secondary market, buying student loans from originating lenders (Sallie Mae stands for Student Loan Marketing Association).

Question 6

The collateral backing private CMOs consists of:

A. private placements offered under Regulation D
B. mortgage backed securities created by a bank-issuer
C. mortgage backed securities issued by a “privatized” government agency
D. mortgages on privately owned homes and apartments

Answer 6

The best answer is B.

Private CMOs (Collateralized Mortgage Obligations) are also called “private label” CMOs. Instead of being backed by mortgages guaranteed by Fannie, Freddie or Ginnie, they are backed by “private label” mortgages - meaning mortgages that do not qualify for sale to these agencies (either because the dollar amount of the mortgage is above their purchase limit or they do not meet Fannie, Freddie or Ginnie’s underwriting standards). Bank issuers make non-conforming mortgages that cannot be sold to Fannie, Freddie or Ginnie and rather than hold them as investments, they can pool them into mortgage backed securities which are then placed into trust and sold as private label CMOs.

Question 7

All of the following statements are true about CMOs EXCEPT:

A. CMO issues have a serial structure
B. CMO issues are rated AAA
C. CMO issues are more accessible to individual investors than regular pass-through certificates
D. CMO issues have the same market risk as regular pass-through certificates

Answer 7

The best answer is D.

CMOs have a lower level of market risk (risk of price volatility due to movements in market interest rates) than do mortgage backed pass-through certificates. Because CMO issues are divided into tranches, each specific tranche has a more certain repayment date, as compared to owning a mortgage backed pass-through certificate. Thus, the price movement of that specific tranche, in response to interest rate changes, more closely parallels that of a regular bond with a fixed repayment date. As interest rates rise, CMO values fall; as interest rates fall, CMO values rise.

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the average maturity will shorten, due to a higher prepayment rate than expected. If the maturity shortens, then for a given fall in interest rates, the price will rise slower.

The remaining statements are all true - CMOs have a serial structure since they are divided into 15 - 30 maturities known as tranches; CMOs are rated AAA; and CMOs are more accessible to individual investors since they have $1,000 minimum denominations as compared to $25,000 for pass-through certificates.

Question 8

Which of the following statements are TRUE about CMOs?

I CMO issues have a serial structure
II CMO issues are rated AAA
III CMO issues are more accessible to individual investors than regular pass-through certificates
IV CMO issues have a lower level of market risk than regular pass-through certificates

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 8

The best answer is D.

All of the statements are true about CMOs. CMOs have a lower level of market risk (risk of price volatility due to movements in market interest rates) than do mortgage backed pass-through certificates. Because CMO issues are divided into tranches, each specific tranche has a more certain repayment date, as compared to owning a mortgage backed pass-through certificate. Thus, the price movement of that specific tranche, in response to interest rate changes, more closely parallels that of a regular bond with a fixed repayment date. As interest rates rise, CMO values fall; as interest rates fall, CMO values rise.

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the average maturity will shorten, due to a higher prepayment rate than expected. If the maturity shortens, then for a given fall in interest rates, the price will rise slower.

CMOs have a serial structure since they are divided into 15 - 30 maturities known as tranches; CMOs are rated AAA; and CMOs are more accessible to individual investors since they have $1,000 minimum denominations as compared to $25,000 for pass-through certificates.

Question 9

Which of the following statements are TRUE regarding CMOs?

I CMOs make payments to holders monthly
II CMOs receive the same credit rating as the underlying pass-through securities held in trust
III CMOs are subject to a lower level of prepayment risk than the underlying pass-through certificates
IV CMOs are available in $1,000 denominations

A. II, III, IV
B. I, II, IV
C. I, III, IV
D. I, II, III, IV

Answer 9

The best answer is D.

Most CMOs make payments to holders monthly; though there are some issues that pay quarterly or semi-annually. CMOs are subject to a lower degree of prepayment risk than the underlying pass-through certificates. During periods of falling interest rates, prepayments of mortgages in a pool are applied pro-rata to all holders of pass-through certificates. CMOs divide the cash flows into “tranches” of varying maturities; and apply prepayments sequentially to the tranches in order of maturity. Thus, prepayments are applied to earlier tranches first, so the actual date of repayment of the tranche is known with more certainty. CMOs receive the same credit rating (AAA or AA) as the underlying mortgage backed pass-through certificates held in trust. CMOs are available in $1,000 denominations, as opposed to pass-through certificates that are $25,000 denominations. This makes CMOs more accessible to small investors.

Question 10

All of the following statements are true regarding collateralized mortgage obligations EXCEPT:

A. CMOs are issued by local government agencies
B. CMOs are backed by agency pass-through securities held in trust
C. CMOs have the highest investment grade credit ratings
D. CMOs give the holder a limited form of call protection that is not present in regular pass-through obligations

Answer 10

The best answer is A.

The last 3 statements are true. Collateralized mortgage obligations are backed by mortgage pass-through certificates that are held in trust. The underlying mortgage backed pass-through certificates are issued by agencies such as FNMA, GNMA and FHLMC, all of whom have an “AAA” (Moody’s or Fitch’s) or “AA” (Standard and Poor’s) credit rating. The CMO takes on the credit rating of the underlying collateral.

CMOs take the payment flow from the underlying pass-through certificates and allocate them to so-called “tranches.” A CMO backed by 30 year mortgages might be divided into 15-30 separate tranches. As payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first.

The CMO purchaser buys a specific tranche. Because of the sequencing of principal repayments from the underlying mortgages, the holder has a more definite maturity date on the issue, as compared to actually buying a mortgage backed pass-through certificate. This is true because prepayments on pass-through certificates are allocated pro-rata. During periods of falling rates, all certificate holders receive their share of those repayments pro-rata. The holder of a specific tranche of a CMO will only receive prepayments after all earlier tranche holders are repaid. Thus, CMOs give holders a form of “call protection” not available in regular pass-through certificates.

CMOs are not issued by government agencies; the agency issues the underlying pass-through certificates. CMOs are packaged and issued by broker-dealers.

Question 11

Which statements are TRUE regarding collateralized mortgage obligations?

I CMOs are backed by agency pass-through securities held in trust
II CMOs have investment grade credit ratings
III CMOs give the holder a limited form of call protection that is not present in regular pass-through obligations
IV CMOs are issued by government agencies

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 11

The best answer is C.

The first 3 statements are true. Collateralized mortgage obligations are backed by mortgage pass-through certificates that are held in trust. The underlying mortgage backed pass-through certificates are issued by agencies such as FNMA, GNMA and FHLMC, all of whom have an “AAA” (Moody’s or Fitch’s) or “AA” (Standard and Poor’s) credit rating. The CMO takes on the credit rating of the underlying collateral.

CMOs take the payment flow from the underlying pass-through certificates and allocate them to so-called “tranches.” A CMO backed by 30 year mortgages might be divided into 15-30 separate tranches. As payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first.

The CMO purchaser buys a specific tranche. Because of the sequencing of principal repayments from the underlying mortgages, the holder has a more definite maturity date on the issue, as compared to actually buying a mortgage backed pass-through certificate. This is true because prepayments on pass-through certificates are allocated pro-rata. During periods of falling rates, all certificate holders receive their share of those repayments pro-rata. The holder of a specific tranche of a CMO will only receive prepayments after all earlier tranche holders are repaid. Thus, CMOs give holders a form of “call protection” not available in regular pass-through certificates.

CMOs are not issued by government agencies; the agency issues the underlying pass-through certificates. CMOs are packaged and issued by broker-dealers.

Question 12

Holders of CMOs receive interest payments:

A. monthly
B. quarterly
C. semi-annually
D. yearly

Answer 12

The best answer is A.

CMO holders receive monthly payments derived from the underlying mortgage backed pass-through certificates. Thus, interest payments are made monthly.

Question 13

Price volatility of a CMO issue would most closely parallel that of an equivalent maturity:

A. Treasury bond
B. Mortgage backed pass-through certificate
C. Treasury STRIP
D. Collateral trust certificate

Answer 13

The best answer is A.

Because CMO issues are divided into tranches, each specific tranche has a more certain repayment date, as compared to owning a mortgage backed pass-through certificate. Thus, the price movement of that specific tranche, in response to interest rate changes, more closely parallels that of a regular bond with a fixed repayment date. As interest rates rise, CMO values fall; as interest rates fall, CMO values rise.

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the average maturity will shorten, due to a higher prepayment rate than expected. If the maturity shortens, then for a given fall in interest rates, the price will rise slower.

Question 14

When comparing the effect of changing interest rates on prices of a CMO issues versus the prices of regular bond issues, which of the following statements are TRUE?

I When interest rates rise, mortgage backed pass through certificates fall in price faster than regular bonds of the same maturity
II When interest rates rise, mortgage backed pass through certificates fall in price slower than regular bonds of the same maturity
III When interest rates fall, mortgage backed pass through certificates rise in price faster than regular bonds of the same maturity
IV When interest rates fall, mortgage backed pass through certificates rise in price slower than regular bonds of the same maturity

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 14

The best answer is B.

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the expected maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the expected maturity will shorten, due to a higher prepayment rate than expected. If the maturity shortens, then for a given fall in interest rates, the price will rise slower.

Question 15

Homeowners will prepay mortgages:

I when interest rates fall
II when interest rates rise
III so they can refinance at lower rates
IV so they can refinance at higher rates

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 15

The best answer is A.

Homeowners will prepay mortgages when interest rates fall, so they can refinance at more attractive lower current rates. They tend not to prepay mortgages when interest rates rise, since there is no benefit to a refinancing.

Question 16

A mortgage backed security that is backed by an underlying pool of 30 year mortgages has an expected life of 10 years. The fact that repayment is expected earlier than the life of the mortgages is based on the mortgage pool’s:

A. standard deviation of returns
B. prepayment speed assumption
C. Macaulay duration
D. loan to value ratio

Answer 16

The best answer is B.

Mortgage backed pass-through certificates are “paid off” in a shorter time frame than the full life of the underlying mortgages. For example, 30 year mortgages are now typically paid off in 10 years - because people move. This “prepayment speed assumption” is used to “guesstimate” the expected life of a mortgage backed pass-through certificate. Note, however, that the “PSA” can change over time. If interest rates fall rapidly after the mortgage is issued, prepayment rates speed up; if they rise rapidly after issuance, prepayment rates fall.

Duration is a measure of bond price volatility. Standard deviation is a measure of the “risk” based on the expected variation of return on investment. The loan to value ratio is a mortgage risk measure.

Question 17

The purchaser of a CMO tranche experiences extension risk during periods when interest rates:

A. rise
B. fall
C. are stable
D. are volatile

Answer 17

The best answer is A.

If interest rates rise, then homeowners will defer moving at the anticipated rate, since they have a “good” deal with their existing mortgage. Thus, the expected mortgage repayment flows from the underlying pass-through certificates slow down, and the expected maturity of the CMO tranches will lengthen. This is extension risk - the risk that the CMO tranche will have a longer than expected life, during which a lower than market rate of return is earned.

Question 18

Which of the following statements are TRUE regarding CMOs?

I When interest rates rise, maturities will lengthen
II When interest rates fall, maturities will shorten
III When interest rates rise, holders are subject to prepayment risk
IV When interest rates fall, holders are subject to extension risk

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 18

The best answer is A.

When interest rates rise, homeowners do not refinance their mortgages, and the prepayment rate will be lower than expected. Thus, the average life of pass-through certificates that represent ownership of that mortgage pool will lengthen; as will the average life of CMO tranches which are derived from those certificates (though not to the same extent). Thus, when interest rates rise, prepayment risk is decreased. On the other hand, extension risk is increased. Extension risk is the risk that the maturity will be longer than expected - during which longer period, the holder receives a lower than market rate of interest.

When interest rates fall, homeowners do refinance their mortgages, and the prepayment rate will be higher than expected. Thus, the average life of pass-through certificates that represent ownership of that mortgage pool will shorten; as will the average life of CMO tranches which are derived from those certificates (though not to the same extent). Thus, when interest rates fall, prepayment risk is increased. On the other hand, extension risk is decreased.

Question 19

Which of the following statements are TRUE about CMOs in a period of rising interest rates?

I CMO prices fall slower than similar maturity regular bond prices
II CMO prices fall faster than similar maturity regular bond prices
III The expected maturity of the CMO will lengthen due to a slower prepayment rate than expected
IV The expected maturity of the CMO will lengthen due to a faster prepayment rate than expected

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 19

The best answer is C.

When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the expected maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

Question 20

Which of the following statements regarding collateralized mortgage obligations are TRUE?

I Each tranche has a different level of market risk
II Each tranche has the same level of market risk
III Each tranche has a different yield
IV Each tranche has the same yield

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 20

The best answer is A.

Each tranche of a CMO, in effect, represents a differing expected maturity, hence each tranche has a different level of market risk. Since each tranche represents a differing maturity, the yield on each will differ, as well.

Question 21

Which Collateralized Mortgage Obligation tranche has the MOST certain repayment date?

A. Planned Amortization Class
B. Targeted Amortization Class
C. Plain Vanilla Tranche
D. Zero Tranche

Answer 21

The best answer is A.

Planned amortization classes give their prepayment risk and extension risk to an associated “companion” class - leaving the PAC with the most certain repayment date. TACs are like a “one-sided” PAC - they protect against prepayment risk, but not against extension risk. Plain vanilla CMO tranches are subject to both risks, while zero-tranches are like “wild cards” - whatever is left over is what you get!

Question 22

When compared to plain vanilla CMO tranches, Planned Amortization Classes have:

A. higher extension risk
B. lower extension risk
C. the same level of extension risk
D. no extension risk

Answer 22

The best answer is B.

Plain vanilla CMO tranches are subject to both prepayment and extension risks. PACs protect against extension risk, by shifting this risk to an associated Companion tranche. Thus, PACs have lower extension risk than plain vanilla CMO tranches.

Question 23

Which statements are TRUE regarding the principal repayments for Companion CMO tranches?

I	Principal repayments made earlier than expected are applied to the Companion class prior to being applied to the Planned Amortization class
II	Principal repayments made earlier than expected are applied to the Planned Amortization class prior to being applied to the Companion class
III	Principal repayments made later than expected are applied to the Companion class prior to being applied to the Planned Amortization class
IV	Principal repayments made later than expected are applied to the Planned Amortization class prior to being applied to the Companion class

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 23

The best answer is B.

Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.

Question 24

Which CMO tranche has the least certain repayment date?

A. Planned Amortization Class
B. Plain Vanilla
C. Companion Class
D. Targeted Amortization Class

Answer 24

The best answer is C.

Companion classes are “split off” from the Planned Amortization Class (PAC) and act as buffers absorbing prepayment and extension risk prior to this risk being applied to the PAC tranche. The PAC, which is relieved of these risks, is given the most certain repayment date. The Companion, which absorbs these risks first, has the least certain repayment date. A Targeted Amortization Class (TAC) is like a PAC, but is only buffered for prepayment risk by the Companion; it is not buffered for extension risk.

Question 25

Which statements are TRUE when comparing Companion CMO tranches to “plain vanilla” CMO tranches?

I Holders of Companion CMO tranches have lower prepayment risk
II Holders of Companion CMO tranches have higher prepayment risk
III Holders of “plain vanilla” CMO tranches have lower prepayment risk
IV Holders of “plain vanilla” CMO tranches have higher prepayment risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 25

The best answer is C.

Older CMOs are known as “plain vanilla” CMOs, because the repayment scheme is relatively simple - as payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first.

A newer version of a CMO has a more sophisticated scheme for allocating cash flows. Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.

Question 26

All of the following statements are true about PAC tranches EXCEPT:

A. If prepayment rates slow down, the PAC tranche will receive its sinking fund payment prior to its companion tranches
B. If prepayment rates rise, the PAC tranche will receive its sinking fund payment after its companion tranches
C. PAC tranche holders have lower prepayment risk than companion tranche holders
D. PAC tranche holders have higher extension risk than companion tranche holders

Answer 26

The best answer is D.

Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments that are made earlier than the PAC maturity are made to the Companion classes before being applied to the PAC (this would occur if interest rates drop); while principal repayments made later than anticipated are applied to the PAC maturity before payments are made to the Companion class (this would occur if interest rates rise). Thus, the PAC class is given a more certain maturity date and hence lower prepayment risk; while the Companion classes have a higher level of prepayment risk if interest rates drop; and they have a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.

Question 27

Which of the following statements are TRUE when comparing CMO PAC tranches to Companion tranches?

I	Principal repayments made earlier than expected are applied to the PAC before being applied to the Companion class
II	Principal repayments made earlier than expected are applied to the Companion class before being applied to the PAC
III	Principal repayments made later than expected are applied to the PAC before being applied to the Companion class
IV	Principal repayments made later than expected are applied to the Companion class before being applied to the PAC

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 27

The best answer is C.

Interest payments on CMOs are made pro-rata to all tranches, but principal repayments that are made earlier than the PAC maturity are made to the Companion classes before being applied to the PAC (this would occur if interest rates drop); while principal repayments made later than anticipated are applied to the PAC maturity before payments are made to the Companion class (this would occur if interest rates rise). Thus, the PAC is given a more certain repayment date; while the CMO is given the least certain repayment date.

Question 28

Which statements are TRUE regarding CMOs?

I	The PAC has a more certain maturity date than the Companion class
II	The Companion class has a more certain maturity date than the PAC
III	The PAC has a higher level of prepayment risk than the Companion class
IV	The Companion class has a higher level of prepayment risk than the PAC

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 28

The best answer is B.

The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches (like plain vanilla CMOs), but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise. Thus, because the PAC has lowered prepayment and extension risk, its yield will be lower than the surrounding Companion classes.

Question 29

Which of the following statements are TRUE when comparing the “Planned Amortization Classes” (PAC tranches) to the Companion Classes of a CMO?

I	Principal repayments made later than expected are applied to the PAC class prior to being applied to the Companion
II	Principal repayments made later than expected are applied to the Companion class prior to being applied to the PAC
III	The PAC has a higher level of extension risk if interest rates rise
IV	The Companion class has a higher level of extension risk if interest rates rise

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 29

The best answer is B.

Principal repayments made earlier than that required (earlier than expected) to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.

Question 30

Which statements are TRUE about CMO Targeted Amortization Class (TAC) tranches?

I TAC tranches protect against prepayment risk
II TAC tranches do not protect against prepayment risk
III TAC tranches protect against extension risk
IV TAC tranches do not protect against extension risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 30

The best answer is B.

A Targeted Amortization Class (TAC) is a variant of a PAC. A PAC offers protection against both prepayment risk (prepayments go to the Companion class first) and extension risk (later than expected payments are applied to the PAC before payments are made to the Companion class). A TAC bond protects against prepayment risk; but does not offer the same degree of protection against extension risk. A TAC bond is designed to pay a “target” amount of principal each month. If prepayments increase, they are made to the Companion class first. However, if prepayment rates slow, the TAC absorbs the available cash flow, and goes in arrears for the balance. Thus, average life of the TAC is extended until the arrears is paid.

Question 31

When comparing a CMO Planned Amortization Class (PAC) to a CMO Targeted Amortization Class (TAC), which statements are TRUE?

I PACs are similar to TACs in that both provide call protection against increasing prepayment speeds
II PACs differ from TACs in that TACs do not offer protection against a decrease in prepayment speeds
III PAC holders have a degree of protection against extension risk that is not provided to TAC holders
IV TAC pricing will be more volatile compared to PAC pricing during periods of rising interest rates

A. I only
B. II and III only
C. I, II, III
D. I, II, III, IV

Answer 31

The best answer is D.

A Targeted Amortization Class (TAC) is a variant of a PAC. A PAC offers protection against both prepayment risk (prepayments go to the Companion class first) and extension risk (later than expected payments are applied to the PAC before payments are made to the Companion class). A TAC bond protects against prepayment risk; but does not offer the same degree of protection against extension risk. A TAC bond is designed to pay a “target” amount of principal each month. If prepayments increase, they are made to the Companion class first. However, if prepayment rates slow, the TAC absorbs the available cash flow, and goes in arrears for the balance. Thus, average life of the TAC is extended until the arrears is paid.

Therefore, both PACs and TACs provide “call protection” against prepayments during period of falling interest rates. TACs do not offer the same degree of protection against “extension risk” as do PACs during periods of rising interest rates - hence their prices will be more volatile during such periods.

Question 32

When comparing a CMO Planned Amortization Class (PAC) to a CMO Targeted Amortization Class (TAC), all of the following statements are true EXCEPT:

A. Both PACs and TACs offer the same degree of protection against extension risk
B. PACs differ from TACs in that TACs do not offer protection against a decrease in prepayment speeds
C. PACs are similar to TACs in that both provide call protection against increasing prepayment speeds
D. TAC pricing will be more volatile compared to PAC pricing during periods of rising interest rates

Answer 32

The best answer is A.

A Targeted Amortization Class (TAC) is a variant of a PAC. A PAC offers protection against both prepayment risk (prepayments go to the Companion class first) and extension risk (later than expected payments are applied to the PAC before payments are made to the Companion class).

A TAC bond protects against prepayment risk; but does not offer the same degree of protection against extension risk. A TAC bond is designed to pay a “target” amount of principal each month. If prepayments increase, they are made to the Companion class first. However, if prepayment rates slow, the TAC absorbs the available cash flow, and goes in arrears for the balance. Thus, average life of the TAC is extended until the arrears is paid.

Therefore, both PACs and TACs provide “call protection” against prepayments during period of falling interest rates. TACs do not offer the same degree of protection against “extension risk” as do PACs during periods of rising interest rates - hence their prices will be more volatile during such periods.

Question 33

A CMO Z-tranche:

A. receives payments prior to all other tranches
B. receives payments after all other tranches
C. receives payments on a pro-rata basis with other tranches
D. does not receive payments

Answer 33

The best answer is B.

A Z-tranch is a “Zero” tranche. It gets no payments until all prior tranches are retired. Then it is paid off at par. It acts like a long-term zero-coupon bond, so it is most susceptible to interest rate risk.

Question 34

Which statements are TRUE regarding Z-tranches?

I Interest is paid before all other tranches
II Interest is paid after all other tranches
III Principal is paid before all other tranches
IV Principal is paid after all other tranches

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 34

The best answer is D.

A Z-tranch is a “zero” tranche that receives no payments, either interest or principal, until all other tranches before it are paid off. It acts like a long-term zero coupon bond.

Question 35

Which statement is TRUE about floating rate tranches?

A. When interest rates rise, the price of the tranche rises
B. When interest rates rise, the price of the tranche falls
C. When interest rates rise, the interest rate on the tranche rises
D. When interest rates rise, the interest rate on the tranche falls

Answer 35

The best answer is C.

A floating rate CMO tranche has an interest rate that varies, tied to the movements of a recognized interest rate index, like LIBOR. Therefore, as interest rates move up, the interest rate paid on the tranche goes up as well; and when interest rates drop, the interest rate paid on the tranche goes down as well. There is usually a cap on how high the rate can go and a floor on how low the rate can drop. Because the interest rate moves with the market, the price stays close to par - as is the case with any variable rate security.

Question 36

Which statement is TRUE about PO tranches?

A. When interest rates rise, the price of the tranche falls
B. When interest rates rise, the price of the tranche rises
C. When interest rates rise, the interest rate on the tranche falls
D. When interest rates rise, the interest rate on the tranche rises

Answer 36

The best answer is A.

A PO is a Principal Only tranche. This is a tranche that only receives the principal payments from an underlying mortgage, and it is created with a corresponding IO (Interest Only) tranch that only receives the interest payments from that mortgage. The principal portion of a fixed rate mortgage makes smaller payments in the early years, and larger payments in the later years. Because of this payment structure, it is most similar to a long-term bond, which pays principal at the end of its life. These are issued at a deep discount to face.

Its price moves just like a conventional long term deep discount bond. When market interest rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because the principal is being paid back at a later date, the price falls. Conversely, when market interest rates fall, the rate of prepayments rises (prepayment risk) and the maturity shortens. Because the principal is being paid back at an earlier date, the price rises.

Question 37

Which statements are TRUE about PO tranches?

I When interest rates rise, the price of the tranche falls
II When interest rates rise, the price of the tranche rises
III When interest rates fall, the price of the tranche falls
IV When interest rates fall, the price of the tranche rises

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 37

The best answer is B.

A PO is a Principal Only tranche. This is a tranche that only receives the principal payments from an underlying mortgage, and it is created with a corresponding IO (Interest Only) tranche that only receives the interest payments from that mortgage. The principal portion of a fixed rate mortgage makes smaller payments in the early years, and larger payments in the later years. Because of this payment structure, it is most similar to a long-term bond, which pays principal at the end of its life. These are issued at a deep discount to face.

Its price moves just like a conventional long term deep discount bond. When market interest rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because the principal is being paid back at a later date, the price falls. Conversely, when market interest rates fall, the rate of prepayments rises (prepayment risk) and the maturity shortens. Because the principal is being paid back at an earlier date, the price rises.

Question 38

Which statement is TRUE about IO tranches?

A. When interest rates rise, the price of the tranche falls
B. When interest rates rise, the price of the tranche rises
C. When interest rates rise, the interest rate on the tranche falls
D. When interest rates rise, the interest rate on the tranche rises

Answer 38

The best answer is B.

An IO is an Interest Only tranche. This is a tranche that only receives the interest payments from an underlying mortgage, and it is created with a corresponding PO (Principal Only) tranche that only receives the principal payments from that mortgage. The interest portion of a fixed rate mortgage makes larger payments in the early years, and smaller payments in the later years. These are issued at a discount to face and each interest payment made brings the “notional principal” of the bond closer to par. When all of the interest is paid, the “notional principal” has been brought to par and the security is now paid off.

The price movements of IOs are counterintuitive! Unlike regular bonds, where when interest rates rise, prices fall, with an IO, when interest rates rise, prices rise! This occurs because when market interest rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because interest will now be paid for a longer than expected period, the price rises. Conversely, when interest rates fall (prepayment risk) the principal is being paid back at an earlier than expected date, so less interest is being received and the price falls (if interest rates fall drastically, the holder might get less interest back than what was originally invested).

Question 39

Which statements are TRUE about IO tranches?

I Payments are larger in the early years
II Payments are smaller in the early years
III Payments are larger in the later years
IV Payments are smaller in the later years

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 39

The best answer is B.

An IO is an Interest Only tranche. This is a tranche that only receives the interest payments from an underlying mortgage, and it is created with a corresponding PO (Principal Only) tranche that only receives the principal payments from that mortgage. The interest portion of a fixed rate mortgage makes larger payments in the early years, and smaller payments in the later years. These are issued at a discount to face and each interest payment made brings the “notional principal” of the bond closer to par. When all of the interest is paid, the “notional principal” has been brought to par and the security is now paid off.

The price movements of IOs are counterintuitive! Unlike regular bonds, where when interest rates rise, prices fall, with an IO, when interest rates rise, prices rise! This occurs because when market interest rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because interest will now be paid for a longer than expected period, the price rises. Conversely, when interest rates fall (prepayment risk) the principal is being paid back at an earlier than expected date, so less interest is being received and the price falls (if interest rates fall drastically, the holder might get less interest back than what was originally invested).

Question 40

Which CMO tranche will be offered at the lowest yield?

A. Plain vanilla
B. Targeted amortization class
C. Planned amortization class
D. Companion

Answer 40

The best answer is C.

Companion tranches are the “shock absorber” tranches, that absorb prepayment risk out of a TAC (Targeted Amortization Class) tranche; or both prepayment risk and extension risk out of a PAC (Planned Amortization Class) tranche. Because the companion absorbs both of these risks, it has the greatest risk and trades at the highest yield. Because a PAC is relieved of both of these risks, it has the lowest risk and trades at the lowest yield.

Question 41

CDO tranches are:

I all rated AAA
II rated based on the credit quality of the underlying mortgages
III can be backed by sub-prime mortgages
IV cannot be backed by sub-prime mortgages

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 41

The best answer is C.

CDOs - Collateralized Debt Obligations - are structured products that invest in CMO tranches (and they can also invest in other debt obligations that provide cash flows). They are used to create tranches with different risk/return characteristics - so a CDO will have higher risk tranches holding lower quality collateral and lower risk tranches holding higher quality collateral.

The housing bubble that ended badly in 2008 with a market crash was fueled by massive issuance of sub-prime mortgages to unqualified home buyers, that were then packaged into CDOs and sold to unwitting institutional investors who relied on the credit rating assigned by S&P or Moodys. These credit ratings agencies really did not understand the complex structure of CDOs and how risky their collateral was (sub-prime mortgage loans that were often “no documentation liar loans”). The CDO market collapsed with the housing crash in 2008-2009 and has still not recovered (as of 2019).

Question 42

CDO tranches:

I have underlying mortgage collateral that is backed by Fannie Mae, Freddie Mac or Ginne Mae
II have underlying mortgage collateral that is backed only by the credit quality of those mortgages
III are all rated AAA
IV are rated based on the credit quality of the underlying mortgages

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 42

The best answer is D.

CDOs - Collateralized Debt Obligations - are structured products that invest in CMO tranches (and they can also invest in other debt obligations that provide cash flows). They are used to create tranches with different risk/return characteristics - so a CDO will have higher risk tranches holding lower quality collateral and lower risk tranches holding higher quality collateral.

The housing bubble that ended badly in 2008 with a market crash was fueled by massive issuance of sub-prime mortgages to unqualified home buyers, that were then packaged into CDOs and sold to unwitting institutional investors who relied on the credit rating assigned by S&P or Moodys. These credit ratings agencies really did not understand the complex structure of CDOs and how risky their collateral was (sub-prime mortgage loans that were often “no documentation liar loans”). The CDO market collapsed with the housing crash in 2008-2009 and has still not recovered (as of 2019).

Question 43

Which security has, as its return, the “pure” interest rate?

A. Treasury Bill
B. Treasury Note
C. Treasury Bond
D. Treasury STRIP

Answer 43

The best answer is A.

Treasury securities are the safest investment - they have virtually no credit risk (default risk) and almost no marketability risk. They do have purchasing power risk (the risk of inflation eroding real returns), but this is only an issue for long-term maturities. Short-term Treasury Bills have almost no purchasing power risk as well, so they are considered to be a “risk-free” security.

The “pure” interest rate is one that is free of any investment risks - it is the “pure” cost of borrowing without any “risk premium” added to the interest rate. Thus, the interest rate on a short-term T-Bill is the “pure” interest rate - the same thing as the risk-free rate of return.

Question 44

A 5 year $1,000 par 3 1/2% Treasury Note is quoted at 101-4 - 101-8. The note pays interest on Jan 1st and Jul 1st. A customer buys 1 note at the ask price. What is the current yield, disregarding commissions?

A. 3.26%
B. 3.46%
C. 3.66%
D. 3.86%

Answer 44

The best answer is B.

The customer buys the bonds at 101 and 8/32s = 101.25% of $1,000 = $1,012.50. The formula for current yield is:

Annual Income
——————– = Current Yield
Market Price

$35
———— = 3.46%
$1012.50

Question 45

Collateralized mortgage obligation tranches that are available to the public are generally rated:

A. AAA+
B. AAA
C. A
D. BBB

Answer 45

The best answer is B.

CMO tranches are generally AAA rated (or have an implied AAA rating because the tranches are backed by GNMA, FNMA or Freddie Mac pass-through certificates). There is no such thing as an AAA+ rating; AAA is the highest rating available. Also note that even though Standard and Poor’s downgraded Treasury Debt to an AA+ rating in the summer of 2011, Moody’s and Fitch’s retained their AAA ratings. For the exam, these securities are still rated AAA.

Question 46

Yield quotes for collateralized mortgage obligations are based upon:

A. average life of the tranche
B. expected life of the tranche
C. 15 year standard life
D. actual maturity of the underlying mortgages

Answer 46

The best answer is B.

Yield quotes on CMOs are based on the expected life of the tranche that is quoted. Do not confuse this with the “average life” of the mortgages in the pool that backs the CMO. This pool, with say an average life of 12 years, is “chopped-up” into many different tranches, each with a given “expected life.” For example, there may be 10 tranches in the pool, with the first tranche having an expected life of 1-2 years, the second tranche having an expected life of 3-5 years, the third tranche having an expected life of 5-7 years, etc.

Question 47

A $1,000 par Treasury Note is quoted at 100-1 - 100-9. The spread is:

A. $.025 per $1,000
B. $.25 per $1,000
C. $2.50 per $1,000
D. $25 per $1,000

Answer 47

The best answer is C.

The spread between the bid and ask is 8/32nds. Remember, government and agency securities are quoted in 32nds (with the exception of T-Bills, quoted on a yield basis). 8/32nds = 1/4th = .25% of $1,000 par = $2.50.

Question 48

The interest earned from which of the following is exempt from state and local tax?

A. Fannie Mae Certificate
B. Ginnie Mae Certificate
C. Real Estate Investment Trust
D. Federal Farm Credit Funding Corporation Note

Answer 48

The best answer is D.

The interest income on U.S. Government obligations and most agency obligations is subject to Federal income tax but is exempt from state and local tax. However, the interest income on mortgage pass through certificates issued by Fannie Mae and Ginnie Mae is fully taxable. Income from REITs is fully taxable as well.

Question 49

Interest received from all of the following securities is exempt from state and local taxes EXCEPT:

A. Fannie Mae Pass Through Certificates
B. Treasury Notes
C. Federal Farm Credit Funding Corporation Bonds
D. Federal Home Loan Bank Bonds

Answer 49

The best answer is A.

The interest income from direct issues of the U.S. Government and most agency obligations is subject to federal income tax but is exempt from state and local tax. An exception is the interest income received from mortgage backed pass through certificates (issued by GNMA, FNMA, FHLMC). This interest income is subject to both federal income tax and state and local tax. The logic behind this tax treatment is that the mortgage interest paid by the homeowners was fully deductible from both federal, state, and local taxes. When this interest is received by the certificate holder, both the federal and state government want to recapture this interest income and tax it.

Question 50

Which of the following statements are TRUE about Treasury Receipts?

I The investor “locks in” a rate of return that is free from reinvestment risk if the Receipt is held to maturity
II The underlying bonds are held by a trustee for the beneficial owners
III The interest income on the Receipts is subject to Federal income tax annually
IV The Receipts are issued by broker-dealers, who maintain a secondary market in these securities

A. III and IV only
B. I, II, III
C. I, II, IV
D. I, II, III, IV

Answer 50

The best answer is D.

Treasury Receipts represent an undivided interest in a portfolio of U.S. Government securities held by a trustee. The portfolio is assembled by a broker-dealer, who sells “receipts” representing ownership of the interest. Each receipt is, essentially, a zero-coupon obligation, that is purchased at a discount, and which is redeemable at par at a pre-set date. Thus, there is no reinvestment risk, since semi-annual interest payments are not received. The implicit rate of return is locked-in when the security is purchased, and the customer will earn that rate of return if the security is held to maturity. The annual accretion amount is taxable, since the underlying securities are U.S. Governments. At maturity, the receipt will have an adjusted cost basis of par, and will be redeemed at par, for no capital gain or loss.

There are no new T-Receipt issues coming to market. Once the Treasury started issuing STRIPS in 1986, there was no need for the “middleman” anymore. However, T-Receipts still trade until they all mature.

Question 51

Which of the following statements are TRUE about Treasury Receipts?

I The interest income on the Receipts is subject to Federal income tax each year
II The interest income on the Receipts is exempt from Federal income tax
III An investment in Treasury Receipts is free from reinvestment risk
IVAn investment in Treasury Receipts is subject to reinvestment risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 51

The best answer is A.

Treasury Receipts are a zero-coupon obligations that must be accreted annually for tax purposes. The annual accretion amount is subject to Federal income tax each year, as the underlying securities are U.S. Governments. Each receipt is, essentially, a zero-coupon obligation, that is purchased at a discount, and which is redeemable at par at a pre-set date. Since semi-annual interest payments are not received, there is no reinvestment risk. The implicit rate of return is locked-in when the security is purchased.

Question 52

The interest received from a Collateralized Mortgage Obligation is subject to:

A. Federal income tax only
B. State income tax only
C. Local income tax only
D. Federal, State and Local income tax

Answer 52

The best answer is D.

The securities underlying CMOs are GNMA or FNMA mortgage backed pass-through certificates. The interest on these securities is subject to both Federal and State and Local income tax; hence CMOs are taxed in the same manner.

Question 53

Which statement is TRUE regarding the tax treatment of the annual adjustment to the principal amount of a Treasury Inflation Protection Security?

A. An annual upward adjustment due to inflation is taxable in that year; an annual downward adjustment due to deflation is not tax deductible in that year.
B. An annual upward adjustment due to inflation is taxable in that year; an annual downward adjustment due to deflation is tax deductible in that year.
C. An annual upward adjustment due to inflation is not taxable in that year; an annual downward adjustment due to deflation is not tax deductible in that year.
D. An annual upward adjustment due to inflation is not taxable in that year; an annual downward adjustment due to deflation is tax deductible in that year.

Answer 53

The best answer is B.

If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income.

(TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)

Question 54

If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is:

A. not taxable
B. taxable in that year as interest income received
C. taxable in that year as long term capital gains
D. taxable at maturity

Answer 54

The best answer is B.

If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income.

(TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)