FCA Securities Revision

Question 1

Limitations of Flat Yield

Answer 1

There are three key drawbacks for using flat yield as a robust measure in assessing bond returns:
* Since it only measures the coupon flows and ignores the redemption flows, it often gives an
incomplete picture of the actual returns from the bond. A bond that has been purchased at a price
that is below the redemption value will be significantly undervalued because the redemption gain is
excluded from the calculation. The opposite is also true when a bond is purchased at a price above
the redemption value.
* The calculation completely ignores the timing of any cash flows and, because there is no discounted
cash flow analysis, the time value of money is completely overlooked.
* If the bond is a floating-rate note (FRN), the return in any one period will vary with interest rates.
If the coupon is not a constant, using a flat-yield basis for measuring returns becomes an arbitrary
matter of selecting which coupon amount among many possible values to use for the calculation.