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Yield To Maturity

The document defines and provides examples of yield to maturity (YTM). It also works through two examples of calculating YTM for bonds: 1) The Mills Company bond that pays 10% annual interest and has a par value of $1,000. It is currently priced at $1,080. The YTM is calculated to be 8.77%. 2) The same Mills Company bond, but it pays interest semiannually instead of annually. In this case, the YTM is calculated to be 8.78%. The document also briefly mentions effective annual rate (EAR).

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hizelarya
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227 views

Yield To Maturity

The document defines and provides examples of yield to maturity (YTM). It also works through two examples of calculating YTM for bonds: 1) The Mills Company bond that pays 10% annual interest and has a par value of $1,000. It is currently priced at $1,080. The YTM is calculated to be 8.77%. 2) The same Mills Company bond, but it pays interest semiannually instead of annually. In this case, the YTM is calculated to be 8.78%. The document also briefly mentions effective annual rate (EAR).

Uploaded by

hizelarya
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Yield to

Maturity (YTM)

Yield to Maturity (YTM)


The yield to maturity is the discount rate that makes the
present value of the bonds promised interest and
principal equal to the bonds observed market price.
Note that the yield to maturity will be equal to the coupon
rate if the bond is selling for its face value.
For premium bonds, the current yield > YTM.
For discount bonds, the current yield < YTM.

Yield to Maturity (YTM)

The Mills Company bond, which currently sells for P1,080, has a
10% coupon interest rate and P1,000 par value, pays interest
annually, and has 10 years to maturity. What is the bonds YTM?

P1,080 = P100 x (PVIFAkd,10yrs) + P1,000 x (PVIFkd,10yrs)

YTM = 8.77%

Yield to Maturity (YTM): Semiannual Interest


Assuming that the Mills Company bond pays interest
semiannually, what is the YTM?

YTM = 8.78%

Effective Annual Rate (EAR)

Bond Valuation: Four Key Relationships


First Relationship:The value of bond is inversely
related to changes in the yield to maturity.

YTM = 12%

YTM rises to
15%

P1,000

P1,000

12%

12%

Maturity date

5 years

5 years

Bond Value

P1,000

P899.44

Par value
Coupon rate

Bond
Value
Drops

Bond Valuation: Four Key Relationships

Bond Valuation: Four Key Relationships


Since future interest rates cannot be predicted, a
bond investor is exposed to the risk of changing
values of bonds as interest rates change.
The risk to the investor that the value of his or
her investment will change is known as interest
rate risk.

Bond Valuation: Four Key Relationships


Second Relationship: The market value of a
bond will be less than its par value if the yield to
maturity is above the coupon interest rate and
will be valued above par value if the yield to
maturity is below the coupon interest rate.

Bond Valuation: Four Key Relationships


When a bond can be bought for less than its par
value, it is called discount bond. For example,
buying a P1,000 par value bond for P950.
Bonds will trade at a discount when the yield to
maturity on the bond exceeds the coupon rate.

10

Bond Valuation: Four Key Relationships


When a bond can be bought for more than its
par value, it is called premium bond. For
example, buying a P1,000 par value bond for
P1,110.
Bonds will trade at a premium when the yield to
maturity on the bond is less than the coupon
rate.

11

Bond Valuation: Four Key Relationships


Third Relationship: As the maturity date
approaches, the market value of a bond
approaches its par value.
Regardless of whether the bond was trading at a
discount or at a premium, the price of bond will
converge towards par value as the maturity date
approaches.

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Bond Valuation: Four Key Relationships


Fourth Relationship: Long term bonds have
greater interest rate risk than short-term bonds.
While all bonds are affected by a change in
interest rates, long-term bonds are exposed to
greater volatility as interest rates change.

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Determinants
of Interest
Rates

Determinants of Interest Rates


As we observed earlier, bond prices vary
inversely with interest rates.
Therefore in order to understand bond pricing
we need to know the determinants of interest
rates.

18

Real Rate of Interest and the Inflation Premium

Quotes of interest rates in the financial press are


commonly referred to as the nominal (or
quoted) interest rates.
Real rate of interest adjusts the nominal rate
for the expected effects of inflation.

19

Real Rate of Interest and the Inflation Premium

The nominal interest rate on a note or bond can be


thought of as including four basic components:
The real rate of interest rate of increase in purchasing power
experienced over time.
An inflation premium premium for the expected increase in
prices of goods and services in the economy over the term of the
bond/note.
The default premium a premium to reflect the risk of default by
the borrower.
A maturity premium a premium that reflects the term structure of
interest rates. In general, longer maturity debt has higher rate.

20

Fisher Effect
The relationship between the nominal rate of
interest, rnominal , the anticipated rate of inflation,
rinflation , and the real rate of interest is known as
the Fisher effect. It is captured in the following
equation:
(1 + rnominal) = (1 + rreal)(1 + rinflation)
rearranging the terms, we can solve for rreal:

21

Fisher Effect
We can also solve for rnominal:
(1 + rnominal) = (1 + rreal)(1 + rinflation)

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Fisher Effect

Example: What is the real rate of interest if the


nominal rate of interest is 10% and the
anticipated rate of inflation is 3%?

rreal = {(1+.10) (1+.03)} 1


= .0680 or 6.80%
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Checkpoint 9.5
Solving for the Real Rate of Interest
You have managed to build up your savings over the three years following your
graduation from college to a respectable P10,000 and are wondering how to
invest it. Your banker says they could pay you 5% on your account for the next
year. However, you recently saw on the news that the expected rate of inflation
for next year is 3.5%. If you are earning a 5% annual rate of return but the
prices of goods and services are rising at a rate of 3.5%, just how much
additional buying power would you gain each year? Stated somewhat differently,
what real rate of interest would you earn if you made the investment?

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The Term Structure of Interest Rates


The relationship between interest rates and time
to maturity with risk held constant is known as
the term structure of interest rates or the
yield curve.
Figure 9-3 illustrates a hypothetical yield curve
of US Treasury Bonds.

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Shifts in the Yield Curve


The term structure of interest rates changes
over time as expectations regarding each of the
three factors that underlie interest rates change.
Figure 9-4 shows the yield curve one day before
911 attack and again two weeks later.

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Shifts in the Yield Curve

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