STATIC CASH FLOW YIELD ANALYSIS
The yield on any financial instrument is the interest rate that makes the present value of the expected cash flow equal to its market price plus accrued interest. For MBS, the yield calculated is called a cash flow yield. The problem in calculating the cash flow yield of an MBS is that the security’s cash flows are unknown, due to the effects of prepayments. Consequently, to determine a cash flow yield some assumption about the prepayment rate must be made.
The cash flows of an MBS typically occur monthly. The convention is to compare the yield on a mortgage-backed security to that of a Treasury coupon security by first calculating the MBS’s bond-equivalent yield
. The bond-equivalent yield for a Treasury coupon security is found by doubling the semiannual yield. However, it is incorrect to do this for an MBS because the investor has the opportunity to generate greater interest by reinvesting the more frequent cash flows. The market practice is to calculate a yield so as to make it comparable to the yield to maturity on a bond-equivalent yield basis. The formula for annualizing the monthly cash flow yield (or the mortgage yield
) for an MBS is as follows:
Bond-equivalent yield = 2[(1 + iM)6 − 1]
is the mortgage yield; that is, the monthly interest rate that will equate the present value of the projected monthly cash flow equal to the market price (plus accrued interest) of the MBS.
All yield measures suffer from problems that limit ...