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UNDERSTANDING THE INTEREST

RATES. Yield to Maturity

Frederick University
2014

Yield to Maturity
The yield to maturity is the
interest rate that makes the
discounted value of the future
payments from a debt instrument
equal to its current value (market
price) today.
It is the yield bondholders receive if
they hold a bond to its maturity.

Bonds: 4 types
Discount bonds - zero coupon bonds
(government bonds)
fixed payment loans

(mortgages, car loans)

coupon bonds
(government bonds, corporate bonds)

consols

Zero coupon bonds


Discount bonds
Purchased price less than face
value
P < F
No interest payments
Face value on maturity

example

90 day bond,
P = 9850, F = 10,000
YTM solves

9850

10,000
(1 i )

90

365

9850

1 i

10,000
(1 i )

90

365

90

365

10000

9850

10000
1 i

9850
10000
i

9850

365

365

90

90

yield on a discount basis

how the bond yields are actually quoted


approximates the YTM

F-P
idb =
F

360
d

example

90 day bond,
P = 9850, F = 10,000
discount yield =

150 360

X
6%
10,000 90

The discount yield vs. the


yield to maturity

idb < YTM

why?
F in denominator
360 day year

fixed payment loan

loan is repaid with equal (monthly)


payments
Each payment is a combination of
principal and interest

fixed payment loan

15,000 car loan, 5 years


monthly payments = 300
15,000 is price today
cash flow is 60 pmts. of 300
what is i?

i is annual rate
but payments are monthly, &
compound monthly
i = i/12

300
300
300
5000

...
2
60
1 i / 12 1 i / 12
1 i / 12

how to solve for i?

Trial and error


Financial tables
Financial calculator
Spreadsheets

Coupon bond
a 2-year coupon bond
a face value F = 10,000,
a coupon rate i = 6%,
a price P =9750.
bond price = PV(future bond
payments)
The coupon payments are
[face value x coupon rate]/2 =

payments are every 6 months for 2 years,


there are a total of 2 x 2 = 4 payment periods.
the yield to maturity, i, is expressed on an annual
basis, so i/2 represents the 6 month discount rate
9750 = 300/(1 + i/2) + 300/(1 + i/2) 2 + 300/(1 + i/2)3 + 300/(1 +
+ i/2)4 + 10000/ ( 1 + i/2)4

or:

9750 = 300/(1 + i/2) + 300/(1 + i/2)2 + 300/(1 + i/2)3 + 10 300/(1 + i/2)4

i = 7.37%

3 important points

The yield to maturity equals the coupon rate


ONLY when the bond price equals the face
value of the bond.
When the bond price is less than the face
value (the bond sells at a discount), the yield
to maturity is greater than the coupon rate.
When the bond price is greater than the face
value (the bond sells at a premium), the yield
to maturity is less than the coupon rate.
The yield to maturity is inversely related to
the bond price. Bond prices and market
interest
rates
move
in
opposite
directions.

Consols (or
perpetuities)
Consols (or perpetuities) promise
interest payments forever, but never
repay principal.

Bond Yields

Yield to maturity (YTM)


Current yield
Holding period return

Yield to Maturity (YTM)

a measure of interest rate


interest rate where

P = PV of cash flows

Current yield

approximation of YTM for coupon


bonds

ic =

annual coupon payment


bond price

Current yield vs. YTM


Better approximation when:
Maturity is shorter
P is closer to F

example

2 year bonds, F = 10,000


P = 9750, coupon rate = 6%
current yield

600
ic =
9750

= 6.15%

current yield = 6.15%


true YTM = 7.37%
lousy approximation

only 2 years to maturity


selling 2.5% below F

Holding period return

Holding period return the return


for holding a bond between periods
t and t+1
sell bond before maturity
return depends on

holding period
interest payments
resale price

Holding period return

Holding period return

C/Pt is the current yield ic

(Pt+1 Pt)/Pt is the capital gain =


g
RET = ic+ g

example

2 year bonds, F = 10,000


P = 9750, coupon rate = 6%
sell right after 1 year for 9900

300 at 6 mos.
300 at 1 yr.
9900 at 1 yr.

300 9900 300


9750

2
i
i
1
1

2
2

i/2 = 3.83%
i = 7.66%

why i/2?
interest compounds annually not
semiannually

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