What are the limitations of the cash flow yield for assessing the potential return from investing in a RMBS?
What will be an ideal response?
The limitations for the cash flow yield in a RMBS are like the yield to maturity for a bond where it is assumed that the coupon payments can be reinvested at a rate equal to the yield to maturity and the bond is held to maturity. These shortcomings are equally present in application of the cash flow yield measure: (i) the projected cash flows are assumed to be reinvested at the cash flow yield, and (ii) the RMBS is assumed to be held until the final payout based on some prepayment assumption. The importance of reinvestment risk, the risk that the cash flow will be reinvested at a rate less than the cash flow yield, is particularly important for many RMBS because payments come as frequently as every month. The cash flow yield, moreover, is dependent on realization of the projected cash flow according to some prepayment rate. If actual prepayments vary from the prepayment rate assumed, the cash flow yield will not be realized.
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