Question

In order to sell the mortgage-backed securities to the pension fund managers (who require low-risk securities) and hedge fund managers (who require high-yield securities), the investment bank decides it will need to turn the MBSs into collateralized mortgage obligations that are segmented into three tranches. The first tranche investors get paid before the investors in the remaining two tranches, the second tranche investors get paid after the first tranche investors and before the third tranche investors, and the third tranche investors get paid after the investors in the other two tranches.

The following tables outline the payment order, yields, and ratings of each of the tranches within three CMOs that the investment bank could create.

Using the tables, answer the questions that follow.

CMO 1

Tranche	Payment Order	Yield	Rating
1	First	3%	AAA
2	Second	10%	BBB
3	Third	15%	CCC

CMO 2

Tranche	Payment Order	Yield	Rating
1	First	7%	BBB
2	Second	13%	CCC
3	Third	14%	CC

CMO 3

Tranche	Payment Order	Yield	Rating
1	First	3%	AA
2	Second	7%	BBB
3	Third	8%	BB

Which CMO would be most appealing to pension fund managers?

CMO 1

CMO 2

CMO 3

Which tranche in that CMO would be most appealing to pension fund managers?

Tranche 1

Tranche 2

Tranche 3

Which CMO would be most appealing to hedge fund managers?

CMO 1

CMO 2

CMO 3

Which tranche in that CMO would be most appealing to hedge fund managers?

Tranche 1

Tranche 2

Tranche 3

Based on your answers to the previous questions, which CMO should the investment manager create so that both classes of investors will purchase the securities?

CMO 1

CMO 2

CMO 3

Answer 1

a) Pension fund manager wants to take the least risk and would therefore invest in the CMO with best rating possible. CMO with AAA rated tranch would be best suited for them.Hence CMO 1

b) Within CMO 1, they would go for tranch 1 as this has the best rating and lowest risk.

c) Hedge fund manager wants to take maximise yield and would therefore invest in the CMO with best possible yield. CMO with highest yield tranch would be best suited for them.Hence CMO 1

d) Within CMO 1, they would go for tranch 3 as this has the best yield.

e) Investment manager would want to create CMO 1 as this is the preferred choice for both type of investors as explained above.