Cash flow yield question cas, limitation, following, question

bchadwick

A and C sound the same (could both be the right answer).. Dumb question to just throw away?
Which of the following assumptions is least likely a limitation of the cash flow yield measure?
A) The computation includes an assumption about the default rate of the underlying loans.
B) MBS or ABSs are held until the final payout based on some prepayment assumption.
C) The credit risk associated with the underlying loans is constant over the life of the security.
Your answer: C was correct!
The cash flow yield measure does not rely on any credit risk assumption. (Study Session 15, LOS 57.a)

jbaldyga

yes exactly. is C just right because there is an assumption made about default rates (choice A) but the assumption made is not constant (choice C)?
I didnt know cash flow yield made any assumption about defaults.

mik82

To forecast the necessary cash flow throughout the life of the MBS or ABS so that one can calculate CFY, a lot of assumptions need to be taken.
- Prepayment
- For non agency MBS, default rates and recovery rates.
Those assumptions (i.e., input numbers) don’t have to be constant over time, thus having to be constant is NOT a constraint for this method. In fact, those assumptions HAVE to vary over time dependent on, among others, forecast about future interest rates, economy development,..
- In addition, there are implicit assumptions of CF reinvested at CFY rate and securities hold until maturity.