Question 1

(a)  Prepayment refers to paying principal on a security before the due date. Prepayment risk is the risk associated with the early unscheduled return of principal on the mortgage pass-through security. The prepayment risks include two main risks namely extension risk and contraction risk.

Extension risk is the risk of the security lengthening in duration owing to the deceleration of payments. Prepayment delays when the interest rates increase because principal cannot be reinvested as much at higher rates. Extension risk occurs because the average life of return of principal gets extended. Extension can be adverse when security is trading at a discount because it delays reinvestment of principal at higher interest rates. Extension may also be beneficial when security is trading at a premium because it delays reinvestment of principal at lower rates.

Contraction risk is the risk of the security shortening in duration owing to acceleration of payments. Prepayment accelerates when interest rates lower, because upside price potential is restricted and cash flows will be reinvested at lower rates. Contraction risk occurs because the average life of return of principal gets shortened. Contraction can be adverse when security is trading at a premium because of capital loss and reinvestment can be made at lower rates. Contraction can be beneficial when security is trading at a discount because of capital gain and reinvestment can be made at higher rates.

(b)  Tranche I has a higher OAS and lower option cost as compared to Tranche II and the effective durations of the two tranches are equal. Rich and cheap securities are identified by comparing the OAS and option costs of the given tranches in a CMO deal. For a given Z-spread and effective duration, cheap securities will normally have high OAS relative to the required OAS and low option costs and rich securities will have low OAS relative the required OAS and high option costs. Cheap securities are undervalued and hence must be bought and vice versa for rich securities. Here Tranche I is undervalued on a relative basis and Tranche II is overvalued, implying that Tranche I is less expensive as compared to Tranche II. Thus Tranche I must be bought and Tranche II must be sold.