

Investment
Analysis & Portfolio Management
(FIN630)
VU
You can
think of the yield to
maturity as an "average" of the spot
rates, or you can visualize
it as a
flat yield curve at some
constant interest rate. This
single interest rate makes
the
present
value of the future cash
flows equal to the bond's
market price.
It is
important to note in the
valuation process that the
yield to maturity is an
afterthefact
calculation.
Investors value each cash
flow by discounting them at
the appropriate spot
rate.
The
sum of these values is the
bond's market price. From
this price we derive the
yield to
maturity.
Realized
Compound Yield:
A modest
complication occurs when
comparing a bond that pays
semiannual interest
with
some
competing investment that pays
interest on a different lime
schedule. If bonds are
being
compared to other securities, you can
best reduce the likelihood
that you compare
apples
with oranges by computing
the effective annual rate
for all of them.
We do
this via equation:
Effective
annual rate = (1+
r/x)x 1
Where;
r=
yield to maturity
x =
number of payments per
year
Current
Yield:
A bond's
yield to maturity measures
the total return the
bondholder receives if the bond
is
kept
for its entire life.
The current yield, only
measures the return
associated with the
bond's
interest
payments. Capital gains or losses
are not included in the
current yield.
Current
yield is an important statistic
for someone primarily
concerned with the
spendable
income
their investments generate. The
fact that the longrun rate
of return (the yield to
ma
turity)
may be higher is not as
important. A zero coupon
bond has a current yield of
zero. It
would
be an inappropriate investment for a
retired person who needed
routine interest
checks
for living expenses.
A
bond whose market price is
less than its par value is
selling at a discount. If the
market
price
is more than the par value,
the bond sells at a premium.
Note that for bonds selling
at a
discount,
the yield to maturity will
always be greater than the
current yield because of
the
capital
gain an investor receives when
the bond matures at par
value. Similarly, for
bonds
selling
at a premium, the yield to
maturity will be less than
the current yield.
The
reason a couponpaying bond
sells for a discount is that
its package of cash flows
is
worth
less than that offered by
the average competing
investment.
Accrued
Interest:
Bondholders
earn interest each calendar
day they hold a bond,
unlike the situation
with
common
stock, where the dividend is
an allornothing feature. Despite this
aspect, firms
generally
only mail interest payment
checks twice each year.
Someone might buy a
bond
today
and receive a check for six
months' interest two weeks
later  a substantial return
in
14
days. The situation does
not work this way,
however, for the story is
incomplete.
172
Table of Contents:

