What are the complications of assessing the potential total return of a CMO tranched using the total return framework?

What will be an ideal response?

The most difficult part of estimating total return is projecting the price at the horizon date. In the case of a CMO tranche the price depends on the characteristics of the tranche and the spread to Treasuries at the termination date. The key determinants are the "quality" of the tranche, its average life (or duration), and its convexity.

Qualityrefers to the type of CMO tranche. Consider, for example, that an investor can purchase a CMO tranche that is a PAC bond but as a result of projected prepayments could become
a sequential-pay tranche. As another example, suppose that a PAC bond is the
longest-average-life tranche in a reverse PAC structure. Projected prepayments in this case might occur in an amount to change the class from a long-average-life PAC tranche to a support tranche. The converse is that the quality of a tranche may improve as well as deteriorate. For example, the effective collar for a PAC tranche could widen at the horizon date when prepayment circumstances increase the par amount of support tranches outstanding as a proportion of the deal.

To test the sensitivity of total return to various alternative assumptions scenario analysis is helpful. Its limitation is that only a small number of potential scenarios can be considered, and it fails to take into consideration the dynamics of changes in the yield curve and the dynamics of the deal structure.