Financial Instruments Toolbox™ supports collateralized mortgage obligations (CMOs) to provide investors with a greater range of risk and return characteristics than mortgage-backed securities (MBS). In contrast to an MBS, which simply redirects principal and interest cash flows to investors on a pro rata basis, a CMO structures cash flows to different tranches, or slices, to create securities that are better tailored to specific investors.
For example, banks might be primarily concerned with extension risk, or the risk that their investment lengthens in time due to increasing interest rates, given that they typically have short-term deposits as liabilities. Insurance companies and pension funds might be concerned primarily with contraction risk, or the risk that their investment will pay off too soon, with liabilities that have much longer lives. A CMO structure addresses the interest-rate risk of extension or contraction with a blend of short-term and long-term CMO securities, called tranches.