Yield to Maturity
Yield to maturity (YTM) is the yield promised by the bondholder on the assumption that the bond will be held to maturity, that all coupon and principal payments will be made and coupon payments are reinvested at the bond's promised yield at the same rate as invested. The YTM s a measurement of the return of the bond. This technique in theory allows investors to calculate the fair value of different financial instruments.
The calculation of YTM is identical to the calculation of internal rate of return.
· If a bond's current yield is less than its YTM, then the bond is selling at a discount.
· If a bond's current yield is more than its YTM, then the bond is selling at a premium.
· If a bond's current yield is equal to its YTM, then the bond is selling at par.
Influencing Factors
"The yield to maturity, or discount rate, is the rate of return required by the bondholders. The bondholder, or any investor, will allow three factors to influence his or her required rate of return." (Block, 2005, p.11)
1. Real rate of return ? This is the rate of return the investor demands for giving up the current use of funds. It is the financial rent the investor charges for using his or her funds for any given period.
2. Inflation Premium ? The investor requires a premium to compensate for the eroding effect of inflation on the value of a dollar. The inflation premium added to the real rate of return ensures that an investor receives their risk free rate of return.
3. Risk Premium - There are two types of risks: business risk ...