Which of the following will have the least average life variability: (i) the collateral,
(ii) the PAC bond, or (iii) the support bond? Why?
What will be an ideal response?
The PAC bond will have the least average life variability because its payment schedule is structured to achieve stability in the cash flows and thus reduce variability in the average life. More details are given below.
The average life variability for the collateral should lie between that for the PAC bond class and the support bond class because the PAC bonds and support bonds are derived from the collateral. The support bond class is used to create a more stable average life for the PAC bond class. PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. This gives a lower variability in its average life. Thus, in terms of least to greatest average life variability, we have: the PAC bond, the collateral, and the support bond.
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