So in the previous recording, we have already discussed how to calculate the coupon

rate
and how to do the calculation for current deal.
Now I'm going to show you how we're going to do the calculation for yield to
maturity
using the trial and error method.
So for that, okay wait for a moment, so for that we're going to write down the bond
valuation
formula, which is your PMT multiplied by, sorry, 1 plus r.
So your R will be, or I'll just leave it R right now, minus N, I'm going to write
the
whole formula so you don't get confused.
Plus we have base value 1 plus R to the power N. Now we're going to plug in the
value.
So bond value, we have this value, 950 rupees, this is the price at which the bond
is selling.
So this is the bond value, this is the price of the bond.
So you can have 950 over here, coupon payment, the coupon payment is all so given
to you in
the question.
So we have 80 multiplied by, now we do not know what the R is, the R is missing
over here.
So I can replace the R by YTM, since that is what we're trying to figure out and it
is
the same as the market interest rate.
And we have YTM over here, even if you just use R, then even then it's fine.
The maturity is six.
The face value is 1000, 1 plus YTM power six.
Now you can see that what were you doing before and what are you doing right now
before you
were given the rate and you were supposed to calculate the bond value.
Now you're given the bond value and you're supposed to find out the rate which is
called
your yield to maturity.
So how are you going to solve this?
You cannot keep YTM on this side and shift everything else on the other side like
we used
to do.
You will have to use the trial and error approach.
The trial and error approach means that you're going to plug in different rates,
assume different
rates and see where is your answer coming 950.
So you might use a rate of let's say 9% and you'll check is my answer coming 950 or
not.
Then you will try maybe a rate of 10% and see is my answer coming 950 or not.
So basically you will plug in this rate 9% here, 9% here, 9% here in all three
places
and you will keep on doing this until your answer is very close to 950.
Now I already know what the YTM is.
So the rate that will give you the correct answer is 9.119% but you can see that
you would have
to try so many multiple times before you get the correct answer which is a very
long and
tedious process if you're doing it manually if you use an Excel spreadsheet or a
financial
calculator then the calculation can be done really quickly and you will get the
exact answer.
So now that we know what the exact answer is, let's see what does this mean.
So I'm going to plug in this interest right over here.
So one minus one plus now this is 9.119% minus six, 9.119%
1,001 plus 9.119% power six.
Now if you do this calculation you will see that your answer is coming very close
to 950.
So if you try this your answer might be coming 949.something or 951.something all
of these
answers are considered to be close sorry about that.
So basically this is what you're supposed to do in the trial and error it is a very
long
and tedious approach.
How are you going to figure out by plugging in different rates that what is going
to be
the exact rate.
So instead of this we do have another methodology which is your approximation
technique.
So this is your approximation formula.
You can use this to get an approximate YDM.
Now the word approximate is used over here so you will not get the exact answer but
yes
you will get a close enough answer if you use this formula.
The C over here represents the coupon payment.
The FV stands for face value the PV is the price of the bond it is the present
value.
The T represents the maturity so basically T over here means N for you.
Again FV and PV we have already discussed.
So let's use this formula in the previous example now.
So we're going to use this formula.
The coupon payment was 80.
The face value was 1000 minus 950 was the price N was 6 and then divided by face
value
again we have 1000 then plus 950 and then divided by 2.
So if you solve this you get 80 plus 8.33 and keeps on going.
And then you have 975 over here and if you solve this you get 9.06 percent.
So multiply your answer by 100 to convert it into a percentage.
Now you can see the correct answer was 9.119 percent and this approximation
technique has
given you an answer of 9.06 percent.
So it's not the exact answer but yes it is close enough that this approximation
methodology
can be used moving ahead.
Now we're coming to another concept which is your yield to call concept.
Okay so the yield to call is different from your yield to maturity yield to
maturity tells
you let's put back to into maturity yield to maturity tells you the total return
that the
investor will get if he holds the bond till maturity whereas yield to call is going
to
tell you the return that the investor will get if the bond gets called.
Now if you're not sure about what is a callable bond I would recommend that you go
back to
the previous units video in order to clarify that we've already discussed this.
A callable bond is a bond that can be called by the issuing company at any
particular time
if there is no deferred call period.
Now basically your corporation if they're calling back the bond before its maturity
that
means that the bond is no longer going to go till maturity and if it's no longer
going
till maturity then the investor is not going to get the return that the yield to
maturity
is telling you they are instead going to get the return till the call date.
So over here you're going to calculate return till the bond gets called so that
will be the
return for the investor in that case if the bond is going to be called by the
corporation.
And we already discussed also that when is corporation most likely going to call
back
the bond.
I hope you can remember that and if you don't remember then do go back and see
those videos.
So now we're saying that this bond is callable is callable after three years at 5%
premium.
So after three years the total maturity of the bond was six years the end was six.
So that means let me make a timeline for this 0, 1, 2, 3, 4, 5, 6.
Now this basically means that if the bond had gone till maturity the investor would
have gotten
these cash flows.
So the coupon rate was 8% 80 so 80 every year plus once a bond would have been
called
back they would have gotten the face value of 1,000 back at the end of the sixth
year.
But now things are different.
Let me just use another color.
Now it is being called after three years so it's going to get called at this point.
So the bond is going to end at this point and if the bond is going to end at this
point
the future and trust payments will not be paid to the investor.
This 1,000 will actually be returned back to the investor over here and the bond is
going
to cease to exist.
It was a loan, right?
A bond is a type of loan.
So if the loan principal amount has been returned at year three the bond will cease
to exist
and the investor will not get the future and trust payments.
Now it is going to be called at a 5% premium because the company is ending the bond
before
the stated maturity they will have to pay a premium on it which is an extra amount.
So they're going to pay a 5% premium on it.
So 1,000 multiplied by 5% that means they're going to pay a premium of 50 on the
bonds instead
of giving just 1,000 back to the investor they're going to give 1,050 back to the
investor.
So now the cash flows for such a person are these.
For such an investor are going to be these big.
So he will get the first year coupon payment, the second year coupon payment, the
third year
coupon payment and at the third year he will get back the bond value plus the call
premium.
Now you want to calculate what is the return of such investor which is your yield
to call.
So for that you can still use the same approximation format as your coupon payment
is 80 plus your
future value.
Now the face value over here is not going to be 1,000 because that is not the value
that
they're getting at maturity at maturity has changed to year three now and at year
three
they're going to get 1050 instead of 1000.
So your face value is going to be 1050 now.
Okay, the price is going to be the same, so that is 950.
The end means maturity, so it's going to get called in three years the maturity is
going
to be three now plus 950 and divided by two.
So if you solve this, this will be 80 plus 33.33 and divided by 1000.
So this will give you 13.33%.
So if the bond completes its maturity, it will give the investor a return of 9.12%.
And if the bond ends before maturity, the investor will get a return of 13.33%.
So the investor will be compensated for the bond that is ending before its time.
But in order to understand this better that why would a corporation that would
still do
that, you should go back and see the recording on the callable bonds, the previous
recording.
So you'll understand that your investor, even though he will get a higher return,
he will
have to invest this 1050 now at a lower interest rate.
So that there is an opportunity cost attached with this higher return actually.
And with this, our topic ends.