Answer: A collateralized mortgage obligation

## Explanation **Correct Answer: B. A collateralized mortgage obligation (CMO)** **Why CMOs provide the highest protection against prepayment risk:** 1. **Structural Protection**: CMOs are structured with multiple tranches (classes) that have different priority in receiving principal payments. This structure allows for better management of prepayment risk compared to pass-through securities. 2. **Sequential Pay Structure**: In a typical CMO, tranches are paid sequentially. The first tranche receives all principal payments (both scheduled and prepayments) until it is fully paid off, then the next tranche begins receiving principal payments. This provides protection to later tranches against early prepayments. 3. **PAC/TAC Tranches**: Many CMOs include Planned Amortization Class (PAC) and Targeted Amortization Class (TAC) tranches that have even more protection against prepayment risk through the use of companion tranches that absorb prepayment volatility. **Comparison with other options:** - **A. Mortgage pass-through security**: These securities have the **lowest** protection against prepayment risk. All investors share pro-rata in both scheduled principal payments and prepayments, making cash flows highly uncertain and sensitive to interest rate changes. - **C. Commercial mortgage-backed security (CMBS)**: While CMBS typically have prepayment protection features like yield maintenance or defeasance, they generally don't provide as structured and predictable protection as CMOs. CMBS prepayment protection is often contractual rather than structural. **Key Takeaway**: CMOs are specifically designed to redistribute prepayment risk among different investor classes, making them the most effective at providing protection against this risk among the options listed.

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