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Q. 7. What do you mean by yield to maturity (YTM) of a bond? Explain briefly.

The yield to maturity (YTM) is an estimated rate of return that an investor can expect from a bond.
This value assumes that you hold the bond until its maturity date. It is also assumed that all interest
payments received are reinvested at the same interest rate as the bond itself. Thus, yield to maturity
includes the coupon rate within its calculation. Yield to maturity is also referred to as "book yield" or
"redemption yield."

A bond's yield can be expressed as the effective rate of return based on the actual market value of
the bond. At face value, usually, when the bond is first issued, the coupon rate and the yield are the
same numbers. However, as interest rates rise or fall the coupon rate offered by the government or
corporation may be higher or lower. This change in interest rates will cause the face/par value of the
bond to change as it tries to stay competitive with other offerings. In this way, yield and price are
inversely proportional or move in equal but opposite directions.

Calculations apply a single discount rate to future payments creating a present value that will be
about equivalent to the bond's price. In this way, the time until maturity, coupon rate, current price,
and the difference between price and face value all are considered.

As some bonds have different characteristics, there are some variants of YTM:

• Yield to call: when a bond is callable, the market looks also to the Yield to call, which is the
same calculation of the YTM, but assumes that the bond will be called, so the cash flow is shortened.

• Yield to put: same as yield to call, but when the bond holder has the option to sell the bond
back to the issuer at a fixed price on specified date.

• Yield to worst: when a bond is callable, puttable, exchangeable, or has other features, the
yield to worst is the lowest yield of yield to maturity, yield to call, yield to put, and others.

Limitations of Yield to Maturity (YTM)

YTM calculations usually do not account for taxes that an investor pays on the bond. YTM also
makes assumptions about the future that cannot be known in advance. An investor may not be able
to reinvest all coupons, the bond may not be held to maturity, and the bond issuer may default on
the bond.
Q. 1. What can a financial institution often do for a deficit economic unit (DEU) that the DEU would
have difficulty doing for itself if the DEU were to deal directly with an SEU

A surplus spending unit is an economic unit with income that is greater than or equal to
expenditures on consumption throughout a period. A surplus spending unit earns more than it
spends on its basic needs and therefore has money left over to invest into the economy through the
form of purchasing goods, investing, or lending. A surplus spending unit can be a household,
business, or any other entity that makes more than it spends for the purpose of sustaining itself. A
surplus spending unit earns more than it spends. Surplus spenders can be individuals, sectors,
countries, or even a whole economy. When a surplus spending unit is an entire country, it can
benefit the global economy by investing in and lending to deficit spending countries.

A deficit spending unit, which spends more than it makes and has to borrow from surplus units to
sustain itself. Once an entity is a surplus or deficit spending unit, it does not have to maintain that
status forever. A deficit spending unit can become a surplus spending unit if it begins to generate
additional income, covers its basic expenses, and pays off all of its own deficits from an earlier
period. Deficit spenders can be individuals, sectors, countries, or even a whole economy. When a
deficit spending unit is an entire country, it is often forced to borrow from countries that operate as
surplus spenders. The effects of deficit spending, if left unchecked, could be a threat to economic
growth. It could force a government to raise taxes and potentially default on its debt.

SEUs typically want to supply a small amount of funds, while DEUs typically want to obtain a large
amount of funds. Thus it is often difficult for surplus and deficit economic units to come together on
their own to arrange a mutually beneficial exchange of funds for securities. A financial institution can
step in and save the day. A bank, savings and loan, or insurance company can take in small amounts
of funds from many individuals, form a large pool of funds, and then use that large pool to purchase
securities from individual businesses and governments.
Q.6 What are efficient portfolios?

An efficient portfolio, also known as an ‘optimal portfolio’, is one that provides that best expected
return on a given level of risk, or alternatively, the minimum risk for a given expected return. A
portfolio is a spread of investment products.

The line that connects all these efficient portfolios is the efficient frontier. The efficient frontier
represents that set of portfolios that has the maximum rate of return for every given level of risk.
The last thing investors want is a portfolio with a low expected return and high level of risk.

No point on the efficient frontier is any better than any other point. Investors must examine their
own risk/return preferences to determine where they should invest on the efficient frontier. But,
theoretically at least, the efficient frontier allows you to reduce your risk at no cost in return. Or you
can increase return at any particular level of risk.

Harry M. Markowitz is credited with introducing new concepts of risk mea-surement and their
application to the selection of portfolios. He started with the idea of risk aversion of average
investors and their desire to maximise the expected return with the least risk. Markowitz model is
thus a theoretical framework for analysis of risk and return and their inter-relationships. He used the
statistical analysis for measurement of risk and mathematical programming for selection of assets in
a portfolio in an efficient manner. His framework led to the concept of efficient portfolios. A set of
efficient portfolios can be generated by using the above process of combining various securities
whose combined risk is lowest for a given level of return for the same amount of investment, that
the investor is capable of. Markowitz emphasized that quality of a portfolio will be different from the
quality of individual assets within it. Thus, the combined risk of two assets taken separately is not
the same risk of two assets together.