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Yeild To Maturity

Essay by   •  July 8, 2011  •  676 Words (3 Pages)  •  995 Views

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In a work environment employees and employers often discuss 401K plans, investment ideas and other bonds and shares. Many individuals do not have a clear idea of investments in the retirement accounts or certificate of deposits maturity process. One employee in our office, raised questions about bonds that were purchased at 10% according to the broker had a yield of maturity of 9%, confusing the individual.

Yield Of Maturity Factors

According to Block and Hirt (2005), the yield to maturity, or discount rate, is the rate of return required by bondholders and three main factors affecting yield of maturity are real rate of return, inflation premium and risk premium. Real rate of return is a return that investors demand after inflation adjustments. Inflation premium is required by investors to compensate the inflation adjustments.

Combining both real rate of return and inflation premium determines the risk-free rate of return. This is the rate that compensates the investor for the current use of his or her funds and for the loss in purchasing power due to inflation but not for taking risks. A risk premium consists of financial risk and business risk to the investor. Business risk relates to the inability of the firm to hold its competitive position and maintain stability and growth in its earnings. Financial risk relates to the inability of the firm to meet its debt obligations as they come due (Block & Hirt, 2005).

Bond and Risk

A bond is a lower risk investment, also called as fixed-income investments. Risk premium can be as low as 2% to 6%. Bonds issued by the federal government are extremely safe. Corporate bonds and municipal bonds, issued by states and cities, can be safe or high-risk (Financialplan.About (2008). The interest rate in bonds is commonly referred to as the coupon rate that matures either quarterly or annually when the bond matures.

Yield of Maturity Process

An employee purchased a bond valued at $1000 at 90%, which means the investor paid $900 for the bond valued at $1000. In another case if an individual purchases a bond at 120% for a bond valued at $1000, the person pays more than the par value. A bond purchased at a discount to par value will have a higher yield to maturity than the bond purchased at higher than par or face value.

For example, a bond has an interest rate of 9%, a coupon face value of $1000 with 10 years to maturity and purchased at 10%. This implies that the individual paid $100 for a bond valued at $1000, the real rate of return will be $90 each year for 10 years after inflation adjustments. Following derivations can explain the theory in concise:

Future Value of Interest Payment

FV = PV (1 +

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