Payments from a CMO

Discussion in 'P2.T5. Market Risk (25%)' started by ChadWOB, May 6, 2012.

  1. ChadWOB

    ChadWOB New Member

    Hi David,

    When calculating the expected payment to investors of a CMO, given;

    The $MV of the CMO, time period (months), pass-through coupon and the weighted average coupons of the underlying ---which coupon figure should be used to calculate the payment?

    My notes on this are unclear to me. I used the pass through coupon to compute the payment, but got a practice question wrong since it used the WAC instead.

    I thought that if the WAC of the underlying was higher than the pass through coupon this just served as a sort of credit enhancement for the CMO, since it is taking in more than it is paying out?
  2. David Harper CFA FRM CIPM

    David Harper CFA FRM CIPM David Harper CFA FRM (test)

    Hi Chad,

    Yes, I agree. Is question mine, if so, can you point to it, so i can check it?
    If you have Excel, maybe my replication of his Table 8-3 will help:
    (although for exam purposes, I'd be careful about too much time on this, could be a time trap and unproven testability)

    I'll use Veronesi's terminology:
    • The mortgage pool, on the asset side, gives the structure its cash inflows. That's WAC, i.e., "Coupon, C(t)" in Veronesi.
    • The securities/notes, on the liabilities side, are outflows to investors. That's "total cash flow" which includes "pass-through interest" to investors; aka, "security coupon rate"
    • As you say, WAC (inflow) should be greater than pass-through coupon rate (outflow to investors). In Veronesi (see XLS), 6.5% WAC > 6.0% r(PT,12).
    • The total cash outflow to investors (notes on liability side) equal sum of: the pass-through coupon (return on capital) + scheduled & prepaid principal (return of capital).
  3. ChadWOB

    ChadWOB New Member

    No this wasn't one of yours. It was a Schweser question on one of their mock exams. Their material is rife with errors.

    Thank you for clearing this up! For what its worth, you've been a great resource for me (am I'm sure many others on this forum) in preparing for this exam. I will certainly spread the word to others pursuing the FRM and/or CFA.

    When I'm done with the FRM (fingers crossed) I'm going to look into your CFP material (since only Schweser was available when I did this one a few years back) as a possible resource for my colleagues pursuing the CFP.
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  4. David Harper CFA FRM CIPM

    David Harper CFA FRM CIPM David Harper CFA FRM (test)


    Thank you, we really appreciate the generous feedback! The issue of errors holds great interest for me; e.g., I trained under a mentor (or two) who cherished quality. So I do value it. But, at the same time, any witness of this forum over the last few weeks, especially while i posted my mock exam questions in near real-time, can see that I make plenty of errors, too. (in fact, we have a customer or two who is currently dissatisfied with our error rate). I do (candidly) think we separate ourselves from the others, and sadly from GARP too, in our follow-up. I think everybody understands that everybody makes some errors, but there is a big difference in how you deal with that knowledge in terms of your process. So, i think it becomes a question about (i) whether there exists a sincere intent to understand the concept details and (ii) whether there is a process to deal with errors conditional on the knowledge that errors will be committed. Thanks!
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