(i) (1 mark) A CMO provides protection against prepayment risk for all tranches.

Note: Assume that the Collateralized Mortgage Obligation (CMO) has three tranches: A, B and C where Tranche A receives principal payments first from the underlying mortgage pool, followed by Tranche B, followed by Tranche C and where all tranches receive interest while they are owed principal.

(ii) (1 mark) Consider an Interest-Only (IO) security. If interest rates go up, the discount rate for valuing the cashflows to the IO security-holders goes up and the price of the IO security will go down.

(iii) (1 mark) Consider a Principal-Only (PO) security. If interest rates go down, the discount rate for valuing the cashflows to the PO security-holders goes down and the price of the PO security will go up.