Part 1 — Introduction to CMOs...................................................................... 7
Collateral Matters ................................................................................................................................. 7
Sequential Structures ............................................................................................................................. 7
Accrual or Z Bonds............................................................................................................................... 9
Accretion-Directed or Very Accurately Determined Maturity (VADM) Bonds ................................... 10
Planned Amortization Class (PAC) Structures ...................................................................................... 13
Targeted Amortization Class (TAC) Structures..................................................................................... 18
Jump Z Structures ................................................................................................................................. 22
Structures With Multiple Redemption Schedules .................................................................................. 24
Variations on the Theme — “Paquential” and Scheduled Classes......................................................... 28
Impact of Changing Market Conditions — Sensitivities to the Yield Curve, Volatility, and
the Mortgage Basis ............................................................................................................................... 28
Convexity and Option Cost.................................................................................................................... 29
Spread Durations................................................................................................................................... 30
Recent Developments ............................................................................................................................ 30
Summary............................................................................................................................................... 31
Part 2 — Introduction to Mortgage Derivatives............................................. 32
Mortgage Derivatives............................................................................................................................ 32
IOs and POs .......................................................................................................................................... 32
Floaters and Inverse Floaters ................................................................................................................. 41
Creating Inverse Floaters and Inverse IOs............................................................................................. 42
Inverses as Investments......................................................................................................................... 45
Understanding Inverse Floaters and Inverse IOs ................................................................................... 46
Volatility Exposure ............................................................................................................................... 53
Prepayment and Spread Exposure.......................................................................................................... 54
Investment Applications ........................................................................................................................ 55
Conclusion ............................................................................................................................................ 59