Limitations of the cash flow yield measure, Financial Management

Bond's potential returns are calculated using measures like Yield to Maturity (YTM) and cash flow yield. Both these measures are not free from shortcomings. The problem with YTM is that we assume that the coupon payments are reinvested at a rate equal to the YTM and the bonds are held up to maturity. By these assumptions, we are ignoring reinvestment risk and interest rate risk. Reinvestment risk is the risk resulting from the fact that interest or dividends earned from an investment may not be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. Interest rate risk is the risk of having to sell a security before its maturity date at a price less than the purchase price. Cash flow yield also ignores reinvestment and interest risk. It assumes that the projected cash flows are reinvested at the cash flow yield and the mortgage-backed or asset-backed securities are held until the final payout based on some prepayment assumption. The reinvestment risk is of utmost importance to mortgage-backed and asset-backed securities as payments from these securities are monthly and both the principal and interest should be reinvested. The assumption that projected cash flow is actually realized may not be true if the prepayment, default and recovery vary from such assumption. 

Posted Date: 9/10/2012 8:08:55 AM | Location : United States







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