Question: Question 4 Consider a sequentially paid Collateralized Mortgage Obligation (CMO) with equal principal tranches A and B, of which A receives principal payment before

Question 4 Consider a sequentially paid Collateralized Mortgage Obligation (CMO) with equal

principal tranches A and B, of which A receives principal payment before

Question 4 Consider a sequentially paid Collateralized Mortgage Obligation (CMO) with equal principal tranches A and B, of which A receives principal payment before B. This CMO is backed by $1,000,000 of mortgages with a 12% (per annum) coupon for both A and B, and has 6 months to maturity. (a) Assuming there is no prepayment and no servicing fees during this 6 months, tabulate the cash flows payment of this CMO. (Please use the template below) (b) (c) INTA INT B Month Mortgage PMT 12% 12% PRN A Repaid PRN B BAL A Repaid BAL B How much is the total interest paid to tranche A and B respectively? (6 marks) (3 marks) How many months does it take to retire tranche A? What is the average life of tranche A? (3 marks) (d) Suppose prepayments are present, and the Single Monthly Mortality Rate (SMM) is 5% per month. Also, given that the outstanding principal balance of the CMO at the end of month 2 is $600,000. (i) How much is the prepayment in month 3? (5 marks) (ii) How much is the outstanding principal balance at the end of month 3? (3 marks) (e) The CMO market has been named as one of the culprits of the subprime crisis in 2008. Briefly explain the reasons why institutional investors were willing to invest in these, on hindsight, highly risky financial instruments. (5 marks)

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