Collateralized Mortgage Obligations and Hedge Funds

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Questions and Answers

Which of the following is not a type of CMO tranche?

TAC

PSA (correct)

PAC

All of the following can be associated with asset-backed securities except?

The securitization of assets.

Pooling individual assets into larger financial securities to be sold to investors.

Expected cash flow from credit card debt, leases, auto loans, and mortgages.

Minimal risk. (correct)

Which of the following risk factors would be least important to disclose in recommending collateralized mortgage obligation (CMO) securities to public customers?

Extended payment risk

Credit risk (correct)

Interest rate risk

Prepayment risk

If one were investing in CMOs, that would be done by buying?

Different tranches. Signup and view all the answers

Hedge funds do not register with the SEC under the Investment Company Act of 1940. As such, hedge funds?

Do not provide the same level of transparency as registered investment companies. Signup and view all the answers

All of the following statements regarding planned amortization class (PAC) collateralized mortgage obligations are true except?

PACs have higher yields than comparable TACs. Signup and view all the answers

Pooling assets such as auto loans and mortgages into investment vehicles for sale to the public is the process known as?

Securitization. Signup and view all the answers

Which of the following is not included in the definition of an investment company under the Investment Company Act of 1940?

A hedge fund Signup and view all the answers

You have a high net worth client who is interested in investing in a hedge fund. Details of the offering would be found in the fund's?

Private offering memorandum. Signup and view all the answers

Investors in collateralized mortgage obligations (CMOs) tend to choose a tranche meeting their maturity expectations. Should the debt continue past the expected payoff date, it is an example of?

Extension risk. Signup and view all the answers

If interest rates fall, which of the following statements regarding collateralized mortgage obligations are true?

I and III. Signup and view all the answers

Why do hedge funds tend to limit participation to a maximum of 100 investors?

Keeping it to 100 or less avoids the need to register with the SEC. Signup and view all the answers

All of the following statements regarding the tax treatment interest received from a collateralized mortgage obligation (CMO) investment is true except?

It is nontaxable at the local level. Signup and view all the answers

An investor wants to invest $20,000 but anticipates needing those funds in five years for a business investment. Which of the following securities would be the least suitable for this investor?

Zero-tranche collateralized mortgage obligation (CMO) with an estimated five years of life. Signup and view all the answers

Study Notes

Collateralized Mortgage Obligations (CMOs)

CMO tranches include PAC (Planned Amortization Class), TAC (Targeted Amortization Class), and Z (Zero tranche). PSA refers to the Public Securities Association and is used for prepayment projections, not a tranche type.
PACs typically offer lower yields than TACs due to lower prepayment risk and more certain maturity dates, supported by two companion tranches to manage risks.

Asset-Backed Securities

Asset-backed securities involve pooling individual loans (such as auto loans and mortgages) into larger financial instruments, facilitating easier sales. This process is known as securitization.
These securities are backed by expected cash flows from the underlying assets but do not guarantee minimal risk.

Hedge Funds

Hedge funds are not registered with the SEC, leading to less transparency compared to registered investment companies. Most hedge fund transactions are in solicited sales and limited to accredited investors.
Limiting participant numbers to 100 avoids SEC registration requirements, ensuring fund managers retain flexibility.

Risks Associated with Investments

Investing in CMOs involves various risks: extension risk arises when repayment continues beyond expected dates; prepayment risk occurs from early payoffs; and interest rate fluctuations impact CMO performance.
Publicly traded mortgage-backed securities are not generally considered illiquid, but they do carry default risk and interest rate risks affecting repayment timings.

Tax Treatment

Interest received from CMOs is fully taxable at the federal, state, and local levels, similar to corporate bond interest. U.S. Treasury and municipal bonds have specific tax exemptions.

Investment Suitability

When considering short-term investment needs, zero-tranche CMOs are the least suitable due to their exposure to interest rate and extension risks. Options like a zero-coupon bond with a maturity close to the investment timeline are more appropriate.

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Description

Explore the concepts of Collateralized Mortgage Obligations (CMOs), asset-backed securities, and hedge funds. This quiz covers crucial aspects like CMO tranches, securitization processes, and the regulatory landscape of hedge funds. Test your understanding and solidify your knowledge in these complex financial instruments.