The prepayment uncertainty of collateralized mortgage obligations

Prepayment risks are today regarded as the most important risks and the least hedgeable risks of mortgages and mortgage-backed securities. It is argued here that the riskiness of a mortgage-related security depends positively on the variance of the duration of that security (and other factors). The CMO tranche structure that arranges investors sequentially to receive amortization payments is the most common form of CMO today. It is shown here that the tranches formed through such a CMO may have less duration uncertainty and less investment risk than underlying mortgages collateralizing the CMO. In some circumstances ALL CMO tranches must have less prepayment risk. Hence the popularity of the CMO could be explained by its effectiveness at reducing prepayment risk.