What does ytm show

It considers all dividends or interest received from the investment during the term of the investment. Yield is different from the total return. Yield is a complete measure of return of an investment as it includes all cash flows from an investment. It can be calculated based on cost and current price. Yield on cost: When the yield is calculated on the purchase price, it is called the yield on cost.

Current yield: When the yield is calculated on the current market price, it is called the current yield. In the Case of Stocks — Yield in case of stocks is the return the stockholder earns on the dividend.

It does not include the profit from selling the shares. In the Case of Bonds — Bond yield is the return one earns on the interest. Interest is also known as the coupon rate. Hence bond yields depend on the coupon rate. In the case of bonds, it is called normal yield. This is the annual return from investing in fixed income securities. However, the investment must be held until maturity, and all the proceeds must be reinvested at a constant rate.

YTM is similar to the current yield where it determines the return one can expect by holding the security for a year. However, YTM is slightly advanced and accounts for the time value of money. Yield to maturity YTM is the total expected return for an investor if the bond is held to maturity. YTM factors all the present values of future cash flows from an investment which equals the current market price.

However, this is based on the assumption that all the proceeds are reinvested back at a constant rate, and the investment is held until maturity. The price of the bond, the coupon payments and maturity value are known to an investor. However, the discount rate has to be computed. This discount rate is the yield to maturity. Often a trial and error basis is used to calculate this. Below is the formula for yield to maturity.

These are reinvested back at a constant rate. However, one can easily calculate YTM by knowing the relationship between bond price and its yield. If the bond is selling at a premium above par value , then the coupon rate is higher than the interest rate. And if the bond is selling at discount, the coupon rate is lower than the interest rate.

This information will help an investor to calculate yield to maturity easily. The current market price of the bond is INR The higher rate of return or yield required, the lower the price of the bond, and vice versa. However, it should be noted that this relationship is not linear, but convex to the origin. The plain vanilla bond with annual coupon payments in the above example is the simpler type of bond.

In addition to the plain vanilla bond, candidates — as part of their Advanced Financial Management studies and exam — are required to have knowledge of, and be able to deal with, more complicated bonds such as: bonds with coupon payments occurring more frequently than once a year; convertible bonds and bonds with warrants which contain option features; and more complicated payment features such as repayment mortgage or annuity type payment structures.

Yield to maturity YTM also known as the [Gross] Redemption Yield GRY If the current price of a bond is given, together with details of coupons and redemption date, then this information can be used to compute the required rate of return or yield to maturity of the bond.

Estimate its yield required rate of return. The internal rate of return approach can be used to obtain r. The YTM is the rate of return at which the sum of the present values of all future income streams of the bond interest coupons and redemption amount is equal to the current bond price. It is the average annual rate of return the bond investors expect to receive from the bond till its redemption.

YTMs for bonds are normally quoted in the financial press, based on the closing price of the bond. For example, a yield often quoted in the financial press is the bid yield. The bid yield is the YTM for the current bid price the price at which bonds can be purchased of a bond. Term structure of interest rates and the yield curve The yield to maturity is calculated implicitly based on the current market price, the term to maturity of the bond and amount and frequency of coupon payments.

The required yield is based on the term structure of interest rates and this needs to be discussed before considering how the price of a bond may be determined.

It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates, would have the same required rate of return or yield. In fact, it is evident that the markets demand different annual returns or yields on bonds with differing lengths of time before their redemption or maturity , even where the bonds are of the same risk class.

This is known as the term structure of interest rates and is represented by the spot yield curve or simply the yield curve.

In this case, the term structure of interest rates is represented by an upward sloping yield curve. The normal expectation would be of an upward sloping yield curve on the basis that bonds with a longer period of maturity would require a higher interest rate as compensation for risk. Changes in interest rates will cause the market value of the bond to change as buyers and sellers find the yield offered more or less attractive under new interest rate conditions.

In this way, yield and bond price are inversely proportional and move in opposite directions. The coupon rate or yield is the amount that investors can expect to receive in income as they hold the bond. Coupon rates are fixed when the government or company issues the bond.

The coupon rate is the yearly amount of interest that will be paid based on the face or par value of the security. Suppose you purchase an IBM Corp. To calculate the bond's coupon rate, divide the total annual interest payments by the face value. While the coupon rate of a bond is fixed, the par or face value may change. When a bond sells for more than its face value, it sells at a premium. When it sells for less than its face value, it sells at a discount. To an individual bond investor, the coupon payment is the source of profit.

To the bond trader, there is the potential gain or loss generated by variations in the bond's market price. The yield to maturity calculation incorporates the potential gains or losses generated by those market price changes.

If an investor purchases a bond at par or face value, the yield to maturity is equal to its coupon rate. If the investor purchases the bond at a discount, its yield to maturity will be higher than its coupon rate.

A bond purchased at a premium will have a yield to maturity that is lower than its coupon rate. YTM represents the average return of the bond over its remaining lifetime. 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, the bond's coupon rate, current price, and the difference between price and face value all are considered.

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