Presentation on theme: "UNDERSTANDING THE INTEREST RATES. Yield to Maturity Frederick University 2014."— Presentation transcript:
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.
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 = = €10,000 x 0.06 x 0.5 = €300.
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 i c = 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 i c = 600 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