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

The correct choice is based on the average life of the quoted tranche of the Collateralized Mortgage Obligation (CMO). CMOs are structured securities backed by a pool of mortgage loans, and they are divided into various tranches, each with its own characteristics and risks. The average life of a tranche refers to the time it takes for the principal of the tranche to be repaid. When quotes for CMOs are made, they typically reflect the yields relative to the average life of the specific tranche being discussed. This is because different tranches have varying levels of prepayment risk due to the underlying mortgage loans that may be paid off earlier or at different rates. The average life provides a measure of how long investors can expect to receive cash flows before the principal is returned, influencing their yield expectations. Conversely, considering factors like the total assets of the CMO or the maturity of the loans does not adequately capture the nuances of how CMOs operate, as nearly all CMOs can experience variations in prepayment rates that directly affect their cash flow and yield based on the tranche's average life. These characteristics make the average life of the quoted tranche the most relevant measure when determining the yield of CMOs.