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Conventional Yield Measures

Conventional Yield Measures. Special Case: Investment with Only 1 Cash Flow Derivation: Ex. Suppose that a financial instrument currently selling for $62,321.30 promises to pay $100,000 six years form now. What is the yield?. Conventional Yield Measures. Current Yield Current Yield =

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Conventional Yield Measures

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  1. Conventional Yield Measures • Special Case: Investment with Only 1 Cash Flow • Derivation: • Ex. Suppose that a financial instrument currently selling for $62,321.30 promises to pay $100,000 six years form now. What is the yield?

  2. Conventional Yield Measures • Current Yield • Current Yield = • Ex. 15 year, 7% coupon bond with a $1,000 PAR value, currently selling for $769.40. What is the current yield? • Strengths: • Weaknesses:

  3. Conventional Yield Measures • Current Yield for Mortgages • Current Yield = • Ex. 15 year, monthly payment mortgage, with a 7% interest rate, and an original loan amount of $200,000. What is the current yield? • Strengths: • Weaknesses:

  4. Conventional Yield Measures • Yield-To-Maturity (YTM) • Yield-To-Maturity = • Ex. Consider a 15 yr., 7% semi-annual coupon bond with a $1,000 PAR value, currently selling for $769.40. What is the yield-to-maturity? • Strengths: • Weaknesses:

  5. Conventional Yield Measures • Yield-To-Maturity (YTM) for Mortgages • Yield-To-Maturity = • Ex. Consider a 15 year, $200,000 monthly payment mortgage, with a 7% contract rate. Monthly payments on the loan are $1,797.66. What is the yield-to-maturity if you purchased this loan on the secondary market five years after origination at a price of $141,910.32? • Strengths: • Weaknesses:

  6. Conventional Yield Measures • Yield-To-Call (YTC) • Yield-To-Call = • Ex. Consider a 15 yr., 7% semi-annual coupon bond with a $1,000 PAR value, currently selling for $769.40. In addition, the bond is callable after five years at a call price of $1,050. What is the yield-to-call? • Strengths: • Weaknesses:

  7. The Cost of Mortgage Credit • Effective Borrowing Cost (EBC) • EBC = • Ex. Consider a 15 year, $200,000 monthly payment mortgage, with a 7% contract rate. Monthly payments on the loan are $1,797.66. If the loan also requires borrowers to pay 2 discount points up-front, what is the effective borrowing cost on this loan?

  8. The Cost of Mortgage Credit • Early Repayment and the EBC • EBC = • Ex. Consider a 15 year, $200,000 monthly payment mortgage, with a 7% contract rate. Monthly payments on the loan are $1,797.66. If the loan also requires borrowers to pay 2 discount points up-front, what is the effective borrowing cost on this loan if the mortgage is repaid after 7 years?

  9. The Cost of Mortgage Credit • Prepayment Penalties and the EBC • EBC = • Ex. Consider a 15 year, $200,000 monthly payment mortgage, with a 7% contract rate. Monthly payments on the loan are $1,797.66. If prepaid, the loan also requires borrowers to pay a 2% prepayment penalty. What is the effective borrowing cost on this loan if the mortgage is repaid after 7 years? What if the loan also requires two discount points be paid up-front?

  10. Yield Decompositions • Potential Sources of a Bond’s Dollar Return • Ex. Decompose the yield on a 15 year, 7% S.A. coupon bond, with a YTM of 10% and a PAR value of $1000. • Conclusions:

  11. Yield Decompositions • Potential Sources of a Mortgage’s Dollar Return • Ex. Decompose the yield on a 15 year, monthly payment mortgage, with a 7% nominal rate of interest and an original loan balance of $200,000. • Conclusions:

  12. Total Return • Methodology:

  13. Total Return Examples • Ex. Consider an investor with a 3 year investment horizon, evaluating a 20-year, $1,000 PAR, 8% S.A. coupon rate bond which is currently selling for $828.40. The stated YTM on the bond is currently 10%, but coupon payments may only be reinvested at 6%. In 3 years, the outstanding bond is expected to be selling to offer a YTM of 7%. What is the total [expected] return offered by this security?

  14. Total Return Examples • Total Return with non-constant reinvestment rates • Ex. Suppose an investor has a 6-year investment horizon and is considering a 13-year, 9% S.A. coupon bond, currently selling at its PAR value ($1,000). The investor expects to be able to reinvest the first 4 semi-annual coupons at 8% (over their entire reinvestment interval), but expects to be able to reinvest the last 8 coupons at 10%. The required YTM on 7-year bonds of similar risk at the end of the investment horizon is expected to be 10.6%. What is the total [expected] return offered by this security? • Limitations of Total Return:

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