Global Edition

Chapter 3
Measuring Yield
 Computing the Yield or Internal Rate of
Return on any Investment

 The yield on any investment is the interest rate that

will make the present value of the cash flows from the
investment equal to the ______ (or _____) of the
investment.

 Mathematically, the yield on any investment, y, is the

interest rate that satisfies the equation:

CF1 CF2 CF3 ...  CFN

P=   
1  y 1  y 2 1  y 3 1  y N
where P = price of the investment, CF = cash flow in year t
=1,2,3,… N, y = yield calculated from this relationship (and
also called the internal rate of return), N = number of years.
 Computing the Yield or Internal Rate of
Return on any Investment (cont’d)

 Absent a financial calculator or computer software, solving

for the yield (y) requires a trial-and-error (iterative)
procedure.

 Keep in mind that the yield computed is the yield for the
period.
 If the cash flows are semiannual, the yield is a semiannual yield.
 If the cash flows are monthly, the yield is a monthly yield.

 To compute the simple annual interest rate, the yield for

the period is multiplied by the number of periods in the
year.
 Computing the Yield or Internal Rate of
Return on any Investment (cont’d)

 Special Case: Investment with Only One

Future Cash Flow
 When there is only one future cash flow, it is not
necessary to go through the time-consuming trial-and-
error procedure to determine the yield.

 We can use the below equation:

1
y CFn  1
n
 P 
 Computing the Yield or Internal Rate of
Return on any Investment (cont’d)

 Annualizing Yields
 To obtain an effective annual yield associated with a
periodic interest rate, the following formula is used:

 effective annual yield = (1 + periodic interest rate)m – 1

where m is the frequency of payments per year

 E.g., if interest is paid quarterly and the periodic interest

rate is 0.08 / 4 = 0.02, then we have:

 effective annual yield = (1.02)4 – 1 = 1.0824 – 1

= .0824 or 8.24%
 Computing the Yield or Internal Rate of
Return on any Investment (cont’d)

 Annualizing Yields
 We can also determine the periodic interest rate that will
produce a given annual interest rate by solving the
effective annual yield equation for the periodic interest
rate.
 periodic interest rate = (1 + effective annual yield )1/m – 1

 E.g., if the periodic quarterly interest rate that would

produce an effective annual yield of 12%, then we have:
 periodic interest rate = (1.12)1/4 – 1 = 1.0287 – 1 =
0.0287 or 2.87%
 Review Question 1 – Return/Yield

 A financial instrument currently selling for $800

promises to pay $1000 three years from now. What
is the yield for this investment? Assume annual
compounding.

7
 Review Q.1 – Answer

 The yield is:

= (1000/800)1/3 – 1
= 7.72%

8
 Review Question 2 – Yield/IRR
 A financial instrument selling for $850 promises to make the following annual payments:

 What is the yield of this investment?

Years from Now Promised Annual Payments

1 100

2 1000

9
 Review Q.2 – Answer

 The yield (y) is computed by solving the following

equation:
850 = 100/(1+y) + 1000/(1+y)2
y = 14.507%

10
 Review Question 3 – Annualizing Yield

 A bank quotes you an annual deposit rate of 6% with

interest paid quarterly. What is your effective annual
yield?

11
 Review Q.3 – Answer

 The effective annual yield is:

= (1 + 6%/4)4 – 1
= 6.1364%

12
 Conventional Yield Measures

 Bond yield measures commonly quoted by dealers

and used by portfolio managers are:
1) Current Yield
2) Yield To Maturity
3) Yield To Call
4) Yield To Put
5) Yield To Worst
6) Cash Flow Yield
7) Yield (Internal Rate of Return) for a Portfolio
8) Yield Spread Measures for Floating-Rate Securities
 Conventional Yield Measures
(cont’d)

1) Current Yield
 Current yield relates the annual coupon interest to
the market price.
Annual Dol l ar Coupon I nt e r e s t
Cur r e nt Yi e l d 
Pr i c e

 The current yield calculation takes into account only

the coupon interest and no other source of return
that will affect an investor’s yield.
 The time value of money is also ignored.
 How to Calculate Current Yield?

 ABC Co. 7 1/8 percent, 4-year, semiannual-pay

bond is trading at 102.347 percent of par (where
par = $1,000). Assume that the bond is callable at
101 in two years, and putable at 100 in two years.
What is the bond’s current yield?

A. 6.962%
B. 7.125%
C. 3.481%
D. 7.328%
15
 Answer

 A
 Current yield = ________/_________ = 0.06962 or
6.962%

16
 Conventional Yield Measures
(cont’d)

2) Yield To Maturity
 The yield to maturity is the interest rate that will
make the present value of the cash flows equal to
the price (or initial investment).

 The yield to maturity is found by first computing the

periodic interest rate, y, which satisfies the
relationship:
C C C C M
P     . . .  
1  y 1  y 2 1  y 3 1  y  n 1  y  n
where P = price of the bond, C = periodic coupon interest (in
dollars), M = maturity value (in dollars), and n = number of
periods (number of years multiplied by m = compounding
frequency)
 Conventional Yield Measures
(cont’d)

2) Yield To Maturity (cont’d)

 For a semiannual pay bond, doubling the periodic
interest rate or discount rate (y) gives the yield to
maturity.
 The yield to maturity computed on the basis of this
market convention is called the bond-equivalent yield.

 The yield-to-maturity calculation takes into account:

(i) the current coupon income,
(ii) any capital gain or loss realized by holding the bond
to maturity, and
(iii) the timing of the cash flows.
 How to Calculate Yield to Maturity (YTM)?

 ABC Co. 7 1/8 percent, 4-year, semiannual-pay

bond is trading at 102.347 percent of par (where
par = $1,000). Assume that the bond is callable at
101 in two years, and putable at 100 in two years.
What is the bond’s yield to maturity?
A. 3.225%
B. 6.450%
C. 6.334%
D. 5.864%

19
 Answer to Example 3-2

 B

8
3.5625 100
102.347   
t 1 (1  YTM / 2 ) t
(1  YTM / 2 ) 8

 YTM  6.45%

Or, n  8, FV  100, PMT  3.5625, PV  - 102.347

 i  ?  3.225 x 2  6.45%

20
 Conventional Yield Measures
(cont’d)

3) Yield To Call
There is a call schedule that specifies a call price for each call date.
The yield to call assumes that the issuer will call the bond at some
assumed call date with the call price specified in the call schedule.
The computation for the yield to call begins with this expression:

P= C  C  C  ... C  M*
1  y 1 1  y 2 1  y 3 1  y  n* 1  y  n*
where M * = call price (in dollars) and n* = number of periods until the
assumed call date (number of years times m)
For a semiannual pay bond, doubling the periodic interest rate (y)
gives the yield to call on a bond-equivalent basis.
 How to Calculate Yield to Call (YTC)?

 ABC Co. 7 1/8 percent, 4-year, semiannual-pay

bond is trading at 102.347 percent of par (where
par = $1,000). Assume that the bond is callable at
101 in two years, and putable at 100 in two years.
What is the bond’s yield to call?
A. 3.167%
B. 5.664%
C. 6.334%
D. 5.864%

22
 Answer

 C
4
3.5625 101
102.347  
t 1

(1  YTC / 2) (1  YTM / 2) 4
t

 YTC  6.334%

Or, n  4, FV  101, PMT  3.5625, PV  - 102.347

 i  ?  3.167 x 2  6.334%

23
 Conventional Yield Measures
(cont’d)

4) Yield To Put
The yield to put is the interest rate that makes the
present value of the cash flows to the assumed put
date, with the put price on that date as set forth in the
put schedule, equal to the bond’s price.

The formula for the yield to put is the same as for the
yield to call, but M * is now defined as the put price and
n* is the number of periods until the assumed put date.

The procedure is the same as calculating the yield to

maturity and the yield to call.
 Conventional Yield Measures
(cont’d)

5) Yield To Worst
A practice in the industry is for an investor to calculate the yield to
maturity, the yield to every possible call date, and the yield to every
possible put date.
The minimum of all of these yields is called the yield to worst.

6) Cash Flow Yield

Amortizing securities involve cash flows that include interest
plus principal repayment and the cash flow each period consists of
three components: (i) coupon interest, (ii) scheduled principal
repayment, and (iii) prepayments.
For amortizing securities, market participants calculate a cash flow
yield, which is the interest rate that will makes the present value of
the projected cash flows equal to the market price.
 Conventional Yield Measures
(cont’d)

7) Yield (Internal Rate of Return) for a

Portfolio
 The yield for a portfolio of bonds is not simply the
average or weighted average of the yield to
maturity of the individual bond issues in the
portfolio.
 It is computed by determining the _____ _____
for the portfolio and determining the interest rate
that will make the present value of the cash flows
equal to the ________ ________ of the portfolio.
 Yield for a Portfolio – An Example

Bond Cpn Rate Maturity Par Value Price YTM Avg YTM Wgt Avg YTM
A 7% 5 10,000 9,209 9% 9.333% 9.279%
B 10.5% 7 20,000 20,000 10.5%
C 6% 3 30,000 28,050 8.5%
Market Value = 57,259

Cash Flows
Period Bond A Bond B Bond C Portfolio Port Yld D.F. PV
1 350 1,050 900 2,300 9.539% 0.9545 2195.29
2 350 1,050 900 2,300 0.9110 2095.35
3 350 1,050 900 2,300 0.8695 1999.96
4 350 1,050 900 2,300 0.8300 1908.91
5 350 1,050 900 2,300 0.7922 1822.01
6 350 1,050 30,900 32,300 0.7561 24422.47
7 350 1,050 1,400 0.7217 1010.37
8 350 1,050 1,400 0.6888 964.37
9 350 1,050 1,400 0.6575 920.47
10 10,350 1,050 11,400 0.6275 7154.02
11 1,050 1,050 0.5990 628.93
12 1,050 1,050 0.5717 600.29
13 1,050 1,050 0.5457 572.96
14 21,050 21,050 0.5208 10963.65
57259.05
 Conventional Yield Measures
(cont’d)

8) Yield Spread Measures for Floating-Rate

Securities
 The coupon rate for a floating-rate security
changes periodically based on the coupon reset
formula.
Reference rate + Quoted margin

 Since the future value for the reference rate is

unknown, it is not possible to determine the cash
flows.
 This means that a yield to maturity cannot be
computed.
 Conventional Yield Measures
(cont’d)

8) Yield Spread Measures for Floating-Rate

Securities (cont’d)
 The most popular margin or spread measure for
floaters is the discount margin, which estimates the
average margin over the reference rate that the
investor can expect to earn over the life of the
security.

 Exhibit 3-1 shows the calculation of the discount

margin for a six-year floating-rate security.
 Conventional Yield Measures
(cont’d)

8) Yield Spread Measures for Floating-Rate

Securities (cont’d)
 The procedure for calculating the discount margin:
i. Determine the cash flows assuming that the reference
rate does not change over the life of the security.

ii. Calculate the YTM for the FRN.

iii. Discount margin = YTM – Reference rate

Exhibit 3-1 Calculation of the Discount Margin for a FRN
Maturity: six years
Coupon rate: reference rate + 80 basis points
Reset every six months

Present Value of Cash Flow at Assumed Annual

Margin (basis points)

Reference Cash
Period Rate Flowa 80 84 88 96 100
1 10% 5.4 5.1233 5.1224 5.1214 5.1195 5.1185
2 10 5.4 4.8609 4.8590 4.8572 4.8535 4.8516
3 10 5.4 4.6118 4.6092 4.6066 4.6013 4.5987
4 10 5.4 4.3755 4.3722 4.3689 4.3623 4.3590
5 10 5.4 4.1514 4.1474 4.1435 4.1356 4.1317
6 10 5.4 3.9387 3.9342 3.9297 3.9208 3.9163
7 10 5.4 3.7369 3.7319 3.7270 3.7171 3.7122
8 10 5.4 3.5454 3.5401 3.5347 3.5240 3.5186
9 10 5.4 3.3638 3.3580 3.3523 3.3409 3.3352
10 10 5.4 3.1914 3.1854 3.1794 3.1673 3.1613
11 10 5.4 3.0279 3.0216 3.0153 3.0028 2.9965
12 10 105.4 56.0729 55.9454 55.8182 55.5647 55.4385
Present Value = 100.0000 99.8269 99.6541 99.3098 99.1381
a
For periods 1–11: cash flow = 100 (reference rate + assumed margin)(0.5); for
period 12: cash flow = 100 (reference rate + assumed margin)(0.5) + 100.
 How to Calculate Discount Margin?

 ABC’s 4-year floating rate bond is currently trading

at 97.65. The coupon, paid annually, is LIBOR + 125
basis points. LIBOR is currently 6.375 percent. What
is the discount margin?

A. 71 basis points
B. 196 basis points
C. 125 basis points
D. 334 basis points
32
 Answer

 B
 Expected coupon = [100 x (0.06375 + 0.0125)] = 7.625
4
7.625 100
97.65   
t 1 (1  YTM ) t
(1  YTM ) 4

 YTM  8.34%

Or, n  4, FV  100, PMT  7.625, PV  - 97.65

 i  8.34%

Discount Margin  8.34 - 6.375  1.96 or 196 basis points

33
 Potential Sources of a Bond’s Dollar
Return
 An investor who purchases a bond can expect to
receive a dollar return from one or more of these
sources:
i. the periodic coupon interest payments made by the issuer
ii. any capital gain (or capital loss) when the bond matures,
is called, or is sold
iii. interest income generated from reinvestment of the
periodic cash flows

 The current yield considers only the coupon interest

payments.
 The yield to maturity, yield to call, and cash flow
yield all take into account the three components.
 Potential Sources of a Bond’s Dollar
Return (cont’d)
 Determining the Interest-On-Interest Dollar
Return (i.e. reinvestment income)
 The coupon interest plus interest on interest can be
found by using the following equation:

 1  r n  1 
coupon interest  interest on interest  C  
 r 

where
C = the periodic coupon interest
r = the periodic reinvestment rate
n = the number of periods
 Potential Sources of a Bond’s Dollar
Return (cont’d)
 Determining the Interest-On-Interest Dollar
Return (cont’d)
 The total dollar amount of coupon interest is found by
multiplying the periodic coupon interest by the number of
periods:
total coupon interest = nC

 The interest-on-interest component is then the difference

between the coupon interest plus interest on interest and
the total dollar coupon interest:

 1  r n  1 
interest on interest  C    nC
 r 
 Potential Sources of a Bond’s Dollar
Return (cont’d)
 Yield To Maturity and Reinvestment Risk
 The investor realizes the yield to maturity only if the bond
is held to maturity and the coupon payments can be
reinvested at the computed yield to maturity.

 Reinvestment risk is the risk that future reinvestment

rates will be less than the yield to maturity at the time
the bond is purchased.

 There are two characteristics of a bond that determine

the importance of the interest-on-interest component and
therefore the degree of reinvestment risk: maturity and
coupon.
 Concept of Interest on Interest (Reinvestment
Income)
 You observe an 8.5 percent semiannual bond with 5 years
to maturity trading at 97.051. The yield to maturity of the
bond is 9.25 percent. How much interest-on-interest
income (in dollars) will you need to earn in order to have
a realized return of 9.25 percent on your investment over
5 years?
A. $8.824
B. $51.124
C. $10.03
D. $52.53
38
 Answer

 C
 N = 10, PMT = 4.25, PV = 0, I = 4.625
=> FV = ? = 52.53
However, the 52.53 include 42.5 in coupon
payments. Therefore, you need to earn:
52.53 – 42.5 = 10.03 in interest on interest income.

39
 Potential Sources of a Bond’s Dollar
Return (cont’d)
 Yield To Maturity and Reinvestment Risk
 For a given yield to maturity and a given coupon rate, the
longer the maturity, the more dependent the bond’s total
dollar return is on the interest-on-interest component in
order to realize the yield to maturity at the time of
purchase.

 For a given maturity and a given yield to maturity, higher

coupon rates will make the bond’s total dollar return
more dependent on the reinvestment of the coupon
payments in order to produce the yield to maturity
anticipated at the time of purchase.
 Total Return Approach

 The yield to maturity is a promised yield because

at the time of purchase an investor is promised a
yield, as measured by the yield to maturity, if both
of the following conditions are satisfied:
i. the bond is held to maturity
ii. all coupon interest payments are reinvested at the yield
to maturity

 The total return (for an investment horizon) is

a measure of yield that incorporates an explicit
assumption about the reinvestment rate.
 How to Find Out the Best Bond to
Invest?
 An investor who has a five-year investment horizon
is considering the following four bonds:

Bond Coupon (%) Maturity (Yrs) YTM (%)

A 5 3 9.0
B 6 20 8.6
C 11 15 9.2
D 8 5 8.0

 Assuming that all four bonds are of the same credit

quality, which is the most attractive to this
investor?
 Total Return Approach (cont’d)

Computing the Total Return for a Bond

The objective is first to compute the total future
dollars that will result from investing in a bond
assuming a particular reinvestment rate.

The total return is then computed as the interest rate

that will make the initial investment in the bond grow
to the computed total future dollars over the
investment horizon.
 Total Return Approach (cont’d)

Computing the Total Return for a Bond

1)Compute the total coupon payments plus the interest on
interest based on the assumed reinvestment rate.
2)Determine the projected sale price at the end of the
planned investment horizon.
3)Sum the values computed in step 1 and step 2.
4)Obtain the periodic total return, using the formula:
1/ h
 total future dollars 
 purchase price of bond  1
 
Where h is the no. of periods
5)Multiply the interest rate found in step 4 by the
compounding frequency  the (annual) total return.
 How to Find Out the Best Bond to Invest
Using Total Return Approach?

Horizon
(Yrs) = 5
Bond Coupon Maturity YTM Price
A 5% 3 9% 89.68
B 6% 20 8.60% 75.38
C 11% 15 9.20% 114.49
D 8% 5 8% 100

Selling Periodic
Reinvestment Price Total Future Rate of Annual
Rate = 5% 10y Yield 15y Yield (Y5) $ Return Return
Coupons + Int.
Bond on int.
A $15.97 $115.97 $128.01 3.623% 7.245%
B $33.61 10.60% 65.82 $99.43 2.808% 5.616%
C $61.62 11.20% 98.81 $160.43 3.431% 6.863%
D $44.81 100 $144.81 3.772% 7.544%
 Applications of the Total Return
Horizon Analysis
 Horizon analysis refers to using total return
to assess performance over some investment
horizon.

 Horizon return refers to when a total return

is calculated over an investment horizon.
 Calculating Yield Changes

 The absolute yield change (or absolute rate

change) is measured in basis points and is the
absolute value of the difference between the two
yields:
absolute yield change = │initial yield – new yield│ × 100

 The percentage change is computed as the natural

logarithm of the ratio of the change in yield:
percentage yield change = ln(new yield / initial yield) × 100
where ln in the natural logarithm
 Practice Questions

12. An investor is considering the purchase of a 20-year 7% coupon

bond selling for $816 and a par value of $1,000. The yield to
maturity for this bond is 9%.

(a) What would be the total future dollars if this investor invested $816 for 20
years earning 9% compounded semiannually?

(b) What are the total coupon payments over the life of this bond?

(c) What would be the total future dollars from the coupon payments and the
repayment of principal at the end of 20 years?

(d) For the bond to produce the same total future dollars as in part (a), how
much must the interest on interest be?

(e) Calculate the interest on interest from the bond assuming that the
semiannual coupon payments can be reinvested at 4.5% every six months
and demonstrate that the resulting amount is the same as in part (d).