General Securities Representative (Series 7) Practice Exam

Which type of CMO has the greatest risk of prepayment?

1. Inverse CMO

2. Plain Vanilla CMO

3. Z tranche

4. Accrual CMO

The correct answer is: Plain Vanilla CMO

The choice of a Plain Vanilla CMO as having the greatest risk of prepayment stems from its structure, which allocates principal payments based on the priority of tranches. Specifically, in a Plain Vanilla CMO, the principal repayments are made to the most senior tranche first, which typically has a lower interest rate and is less exposed to the fluctuations in prepayment speeds. Prepayment risk is significant in mortgages and CMOs because borrowers may choose to refinance or pay off their loans early, especially when interest rates decline. This can lead to a situation where investors in the senior tranches of a Plain Vanilla CMO receive their principal back sooner than anticipated, potentially at less favorable reinvestment rates. In contrast, other CMO types, such as Z tranches or accrual CMOs, are typically designed to defer principal repayments until later. Z tranches receive no principal until all other tranches are paid off, while accrual tranches accumulate interest rather than receiving cash payments, thus providing a buffer against prepayment risk. Inverse CMOs, while complex, also have different prepayment dynamics due to their structured interest payments based on movements in underlying interest rates. Therefore, the risk associated with prepayments is most pronounced for Plain Vanilla CMOs due