General Securities Representative (Series 7) Practice Exam

CMO quotes are based on yields related to what?

1. The total assets of the CMO

2. The maturity of the loans

3. The average life of the quoted tranche

4. The principal amount of the mortgage

The correct answer is: The average life of the quoted tranche

CMO quotes are based on yields related to the average life of the quoted tranche. Understanding this is crucial because Collateralized Mortgage Obligations (CMOs) are structured financial products that pool together mortgage loans and divide them into different tranches, each with its own risk and return profile. The average life of a tranche refers to the expected duration over which the principal balance of the tranche will be repaid, which is influenced by factors such as prepayments, interest rates, and the specific cash flow characteristics of the underlying mortgage loans. When assessing the yield of a CMO, investors look at the average life because it provides insight into the timing of cash flows and the associated risks. A shorter average life may yield lower returns but comes with reduced risk from interest rate fluctuations, while a longer average life might offer higher potential yields but also greater sensitivity to prepayment risks and changes in interest rates. Yield quotes for CMOs specifically account for the characteristics of the tranche in question, as different tranches will have different average lives based on their seniority and payment structures. Therefore, focusing on the average life is essential for understanding the yield and associated risks for that specific tranche.