The paper 'Bond Yield Measures' is a great example of a Macro and Microeconomics Case Study. A bond is a debt investment by an investor whereby he loans money to a corporate or a government entity that borrows funds to conduct its businesses for a given time period and the investor earns an interest rate that is usually fixed (Hearth, Jarrow, and Morton, 2006). Mostly the interest rate is computed as a percent of the principal amount of the bond. A bond is also called fixed income securities and together with cash equivalents and stock, they make up the three main classes of assets.
An investor uses different methods to determine the rate of return on different bonds so as to make their investment decisions appropriately (Korajczk and Levy, 2009). The prices of bonds are usually influenced by the prevailing interest rates in the markets. When interest rates are rising, bonds are priced differently compared to when they are falling (Bekaert, Harvey, and Lumsdaine, 2009). This report outlines the different yield measures that can be used by investors and the effects of changes in interest rates on bond prices. 2.0 Types of bond yield measures 2.1 Current yield Current is basically a measure used to approximate the rate of return of a coupon bond (Black and Scholes, 2011).
Simply it is the coupon payment made annually divided by the bond price (C/P, C stands for annual coupon payment while P stands for the price of the bond). Among all yields measure, the current yield measure is the simplest measure to use (Bekaert, Harvey, and Lumsdaine, 2009). It is a better approximation for bonds that have a long maturity period and mostly preferred when the bond price is closer to the bond’ s face value. Example Calculate the current yield of a treasury note with a duration of two years, it has a face value of $ 1,000, its coupon rate is 6% and the price of the Treasury note is $ 975. Annual coupon payment= 6% * 1000 = 60 Current yield= annual coupon payment/bond price 60/975 = 6.15% 2.2 Yield to maturity Yield to maturity refers to an interest rate that makes the price of the bond and the cash flow present value equal (Heath, Jarrow, and Morton, 2006).
The yield to maturity of a semiannual pay bond is determined by first calculating periodic interest rate denoted ‘ y’ and satisfies the following relationship: P = P= bond price, C= semiannual coupon interest, M= maturity value, N= number of periods (since its semiannual pay bond). The yield to maturity is given by doubling the discount rate or periodic interest rate (Bekaert, Harvey, and Lumsdaine, 2009). For a bond that is a zero-coupon one, computing its yield to maturity is much easier (Davis and stone, 2009) and the formula used is: When calculating yield to maturity, one not only takes into consideration coupon rate income, the capital loss or gain is also considered that will be realized by the investor for holding the bond up to maturity (Hearth, Jarrow, and Morton, 2006).
Furthermore, the timing of cash flows is also taken into account when calculating the yield to maturity of a bond. Example Consider a treasury bond with a par value of $ 10,000, a coupon rate of seven percent and a maturity period of 5 years. The interest is paid semi-annually ant the price of the bond is 8842.
Calculate the yield to maturity of the bond.
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