Risk Type #1 = contraction risk; Risk Type #2 = extension risk
Contraction risk refers to the shortening of the expected life of the mortgage pool due to falling interest rates and higher prepayment rates. There are two undesirable consequences for passthrough investors when interest rates decline. First, the security exhibits negative convexity, meaning that the opportunity for gains when rates fall is taken away. Second the security receives heavier than expected cash flows at the wrong time because low interest rates increase the reinvestment risk of the investment.
Extension risk refers to the lengthening of the life of the security as interest rates rise. With passthrough securities, the decrease in prepayments compounds the price decline because the lower than expected cash flows occur at the wrong time because investors would rather recapture their principal as soon as possible when rates are high.
For sequential pay CMO tranches, each class of bond gets retired sequentially, meaning that tranche A gets retired first, then tranche B, and so on. The Z tranche is the last tranche to be repaid and does not receive current interest until the other tranches have been paid off.
Thus, the early payment tranches, beginning with tranche A, have the highest amount of prepayment risk and get retired first. Here the contraction is great, and the probability of extension is small. However, the late tranches, especially the Z tranche, receives little if any prepayments and suffers low to no contraction risk but high risk of extending the life of the security.
