# Payments from a CMO

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

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 FRMDavid Harper CFA FRM (test)

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: https://www.dropbox.com/s/wo8g717oko81d0b/Veronesi_Table8_3.xlsx
(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).
Thanks,

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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