In the late 80s, American investment bankers introduced floating rate CMOs aimed at the Euromarket. Ordinary CMOs are backed by fixed rate mortgages and payments to investors reflect these fixed rates. Floating rate CMOs are also backed by fixed rate mortgages, but the payments to the various classes of investors are divided up so that at least "one class" receives interest payments that float at the current market rate while another receives the residual payments.

a. Which would you expect to offer a higher yield: an ordinary fixed-rate CMO or the floating rate class of the new CMO? Why does this difference occur?

b. Given that the payments promised to investors in the floating rate class and the residual

class of the new CMO must sum to the payments provided by the underlying fixed-rate

mortgages, how will payments to the residual class change when market interest rates increase?

c. Given this behavior, will the residual class offer a higher or lower yield than the

traditional CMO? Why?

d. In light of your answers above, do you feel that in total the issuers came out ahead by

using the new structure? Explain why or why not.