What is the relationship between Principal Only (PO) and Interest Only (IO) tranches?

The relationship between Principal Only (PO) and Interest Only (IO) tranches is indeed one of inverse correlation, which is why the selection of the answer indicating that the values of POs and IOs are inversely related is correct.

To understand this relationship, it's essential to recognize the cash flow mechanisms of each tranche. Principal Only tranches provide investors with cash flows consisting solely of the principal repayments from the underlying mortgage loans or securities. As principal is repaid, the value of the PO tranche increases. Conversely, Interest Only tranches pay investors cash flows that consist solely of the interest portion of the mortgage payments. As more principal is paid off, the interest payments decline, leading to a decrease in the value of the IO tranche.

This inverse relationship is driven by the fact that when borrowers pay down their loans, more cash flows contribute to the PO tranche, which increases its value at the expense of the IO tranche, whose value diminishes as interest payments decline due to reduced outstanding principal. Thus, when the prepayment rates are high, PO values increase while IO values decrease, reinforcing the inverse relationship.

The incorrect options do not accurately capture this critical aspect:

• The idea that POs and IOs are directly related in value conflicts with their