A collateralized mortgage obligation pays a 2% coupon rate on the first tranche plus any prepayments until its $50 million par value is retired. The second and third tranches receive 4% and 5% coupon rates. The third tranche receives principal only after the second is retired. Which statement is most accurate?

a) Each tranche has the identical level of risk
b) The first tranche has the highest prepayment risk
c) The second tranche has no prepayment risk
d) The third tranche is the least risky

The correct answer is b) The first tranche has the highest prepayment risk.

Explanation:

A collateralized mortgage obligation (CMO) is a type of security backed by mortgage. It is comprised of a pool of mortgages that are bundled together and sold as an investment. Prepayment risk is the risk of loss of interest income due to early repayment of the principal by the borrower.

In the given situation, there are three tranches. The first tranche has the highest prepayment risk because it is receiving principal at the earliest. Hence, there is more of a chance of this principal being returned early and the CMO holder losing out on potential interest. Therefore, the prepayment risk of the first tranche is the highest among all three tranches.

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