Question

OS. A CMO has two tranches. Tranche A has a principal value of $120 million and pays 5 percent annually. Tranche B has a principal value of $100 million and pays 7 percent annually. 1) If at the end of the first year, the CMO trustee receives total cash flows of $36 million, how are they distributed? 2) If in the second year, the CMO trustee receives the same cash flows of S36 million, how are they distributed? 3) Now assuming that at the beginning of the 5th year, Tranche A has S20 milion principal outstanding, and the CMO trustee receives total cash flows of $36 million, how are they distributed?

Answer 1

The sequence of payments will be as follows :

First we will make the coupon payments to Tranche A and Tranche B; then we will make the principal payment of Tranche A and at last we will make the principal payment of Tranche B.

At the end of first year, the cash flows of $36 million will be distributed as :

Coupon payment to Tranche A : $120 million * 5% = $6 million

Coupon payment to Tranche B : $100 million * 7% = $7 million

Principal payment to Tranche A : $36 million - $6 million - $7 million = $23 million

So, the remaining principal payment of Tranche A = $120 million - $23 million = $97 million

In the second year, the cash flows of $36 million will be distributed as :

Coupon payment to Tranche A : $97 million * 5% = $4.85 million

Coupon payment to Tranche B : $100 million * 7% = $7 million

Principal payment to Tranche A : $36 million - $4.85 million - $7 million = $24.15 million

So, the remaining principal payment of Tranche A = $97 million - $24.15 million = $72.85 million

In the fifth year, the cash flows of $36 million will be distributed as :

(It is given that the remaining principal outstanding of Tranche A is only $20 million)

Coupon payment to Tranche A : $20 million * 5% = $1 million

Coupon payment to Tranche B : $100 million * 7% = $7 million

Amount left after coupon payments : $36 million - $1 million - $7 million = $28 million

Principal payment to Tranche A : $20 million

Principal payment to Tranche B : $28 million - $20 million = $8 million.

So the principal outstanding of Tranche B = $100 million - $8 million = $92 million.