Products & Their RisksQuestion 168 of 398
A key risk unique to owning a CMO compared with a plain Treasury bond is:
a.Currency risk
b.Prepayment (extension and contraction) risk from the underlying mortgages
c.Exemption from all federal taxes
d.The complete absence of interest rate risk
Explanation
Because a CMO's cash flows come from a pool of mortgages, its actual maturity depends on how fast homeowners prepay. When rates fall, prepayments speed up (contraction risk); when rates rise, prepayments slow and the CMO's life extends (extension risk). A plain Treasury bond has a fixed maturity and no such prepayment uncertainty.
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