Outline IntroductionMeasures of yieldYield to MaturityCurrent Yield Yield to CallYield to PutInterest rate Theories influencing investors in choosing a yieldReferencesIntroductionEvery investor is interested in the return he gets from an investment made. Therefore it is necessary for one to calculate the yield that has a present value equal to the original cost or investment amount. It is expressed as a percentage and the factors in its calculation include the face value of the bond, the years to maturity, coupon rate and the current value of the bond in the market. Investors would prefer to hold on to bonds with positive convexity during increasing market interest rates (Besley and Brigham, 2008).
Any cost to be for an investment is calculated as P = Where P is the maximum price that an investor should make when purchasing a bond, CFt is cash flow in year t and y is yield. In most instances y is calculated using internal rate of return methods of trial and error. There are many measure of yield which includes Yield to maturity, realised yield and expected yield, Current Yield, Yield to Call, Yield to Put, Yield to Worst and Cash Flow Yield (Crescenzi, 2010).
Measures of yieldYield to Maturity- Yield to maturity is the yield that an investor will have if he holds the bond to maturity and during that period all interest earned is expected to be reinvested. It is considered the present value of all cash flows made from the bond. It is the rate or return expected or promised on a bond if the bond is held by the investor till maturity of the bond.
It is expressed as a percentage and the factors in its calculation include the face value of the bond, the years to maturity, coupon rate and the current value of the bond in the market (Fischer and Jordan, 2006). It is calculated as Where: is value of bond, is annual interest, is required rate of interest, is principal value of maturity and n is life of bondIt is easy to see that although bonds carry a promise to maintain a constant-dollar interest payment to maturity, I, and pay a fixed principal at maturity, P, the number of years to maturity, N, and the required rate of interest, i, can vary. Assume the bond with the Le us assume a 10-year bond with a principal value of $1,000, bearing a nominal rate of interest of 10 percent.
Assume that an investor wishes to purchase this bond for a rate of percent. Because bond interest is normally paid twice a year, $100 of interest per annum would be paid in two semi-annual instalments of $50 each. The 10 percent annual rate is thus 5 percent per six-month period.
The bond was purchase at $ 780. One will begin with calculating internal rate of return of the bond using cash flows up to maturity. The present value of the interest-payment stream of $100 per year for 10 years is as follows: V=P+V=50+ = 952.38 +376.89 = $1,329.27The present value of the principal at maturity is $1,000/ (1+. 05)20= $376.89. The total value of the bond is thus $952.38 + $376.89, or $1,329.27. In other words, a $1,000 bond is worth $1,329.27 today if the nominal rate and the required rate of interest are equal.
The $1,000 value is a composite of $952.38 of interest payments and $376.89 of principal. Note that the principal is compounded twice a year, as are interest payments.