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Bond Yield Under Various Assumptions - Essay Example

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Bond Yield Under Various Assumptions I. Overview Bond valuation and yield uses the concept of present values for assessments. Friedlob and Schleifer (2003, p. 36) defined the present value as value of future cash flows discounted to their “present value at an appropriate interest rate.” For example, using slide 14 of our PowerPoint slides, “Bond prices and interest rate risk,” the present value of a bond with zero coupon is the present value of its face value or …
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Bond Yield Under Various Assumptions

Download file to see previous pages... Nevertheless, the concept of the price of a zero coupon bond articulated in the PowerPoint slides and the concept of the present value are similar. One of the more important concepts in bond valuation is term to maturity. Term to maturity “specifies the date or number of years before a bond matures (or expires)” (Reilly and Brown, 2002, p. 697). Another important concept is the coupon of bond which “indicates the income that the bond investor will receive over the life (or holding period) of the issue” of a bond (Reilly and Brown, 2002, p. 697). Other than concepts term to maturity and coupon of bond, the other important concepts include the principal or the par value of the bond but the public is generally familiar with these concepts. II. Measures of Bond Yield Under Various Assumptions (and examples) There are at least five measures of bond yield. Each measure involves a set of assumptions. 1. Yield to Maturity (YTM) As pointed out by our PowerPoint slides, “Bond prices and interest rate risk”, the yield to maturity or YTM “is the yield promised to the bondholder if the bond held up to maturity and all coupons are reinvested at the promised yield” (Slide 17, “Bond prices and interest rate risk”). ...
214-215). Fabozzi (2008, p. 214) confirmed that yield to maturity “is the interest rate that will make the present value of the cash flow from a bond equal to its market price plus accrued interest.” Fabozzi (2008, p. 214) pointed out that “an iterative procedure is used to find the interest rate that will make the present value of the cash flows equal to the market price plus accrued interest.” Following the Fabozzi (2008, p. 214) example, suppose a bond with a face value of $100 promising payments of 7% per annum payable semi-annually or every six months is being sold at $94.17. Based on the parameters defined for the bond, the bond will earn for the bond buyer the value of $3.50 every six months plus $100 at the end of the eight year. Fabozzi (2008, p. 214) pointed out that when the discount rate used to obtain the present value of the payments from the bond is 3.5%, the present value of the bond is $100.00. When the discount rate of 3.6% is used to determine the present value of payments from bond, the present value of the bond is $98.80. When the discount rate of 3.7% is used, the present value of the bond is $97.62. When the discount rate of 3.8% is used, the present value of the bond is $96.45. When the discount rate of 3.9% is used, the present value of the bond is $95.30. Finally, when the discount rate of 4.0% is used, the present value of the bond is $94.17. Thus, based on these, Fabozzi (2008, p. 214) concluded that 4.0% is the price of the bond and “hence, 4.0% is the semi-annual yield to maturity.” All computations came from Fabozzi (2008). Thus, we can consider that the yield to maturity or YTM of the bond as the interest actually paid to the investment of $94.17 made by the buyer of bond and the cash flows of $3.50 ...Download file to see next pagesRead More
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