Normal spread, Financial Management

After the calculation of cash flow yield and the average life of the asset-backed and mortgage-backed security based on default, prepayment and recovery assumptions, the next thing to do is to compare the yield to a benchmark yield. Benchmark yield is the yield of treasury security which has the same maturity as the security's average life. Nominal spread is defined as the difference between cash flow yield and the yield of a comparable Treasury security. A normal spread has certain disadvantages. A part of nominal spread is compensation for accepting prepayment risk. Let us consider CMO support tranches that have been offered at a huge nominal spread. As we have seen earlier, nominal spread embodies substantial prepayment risk associated with support tranches. If a manager buys these CMO support tranches based on nominal spread, he will not succeed in determining whether or not the offered nominal spread is an adequate return given the substantial prepayment risk the support tranche holder has faced. Therefore, the manger should use measures like option-adjusted spread to indicate the potential compensation after adjusting for prepayment risk. 

Posted Date: 9/10/2012 8:09:52 AM | Location : United States

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