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Yield To Maturity

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Running Head: YIELD TO MATURITY

Yield to Maturity Paper

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University of Phoenix Online

Yield to Maturity Paper

There are many instruments to invest money in. Deciding upon which one to use means that the investor needs to fully understand the ins and outs of each instrument. By understanding the different instruments the informed investor can then evaluate which one provides the best return on the investment and proceed accordingly. One type of investment option is a bond, which is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest at a later date, termed maturity (Wikipedia). The market value of a bond can change after it is issued, so understanding the factors that can influence the value can be crucial in making informed financial decisions. If a 10% bond has a 9% yield to maturity, what does that mean?

Yield to Maturity

Interest and yield to maturity are two terms commonly used to describe bonds. Interest is the price paid for borrowing money, generally expressed as a percentage of the amount borrowed paid in one year (Webster's). For example, a $1,000 bond with a 10% interest rate will yield $100 in interest (assuming a maturity date of 1 year and interest is paid at the maturity date). The yield to maturity is used to define the rate of return that an investor will receive if a long-term bond is held until its maturity date (Oglesby, 2007). The rate of return, also known as the discount rate, is influenced by three factors (Block, 2005):

1. the required real rate of return,

2. inflation premium, and

3. risk premium.

The real rate of return is also known as the financial "rent" that an investor charges for using the funds. The inflation premium is designed to compensate the investor for the effect of inflation eroding the value of their dollar. The risk premium is a compilation of the risks associated with the competitive nature of the industry and the company being able to meet its financial obligations. Adding these three factors together produces the rate of return on the investment.

As the rate of return changes, the price of the bond changes. For example, if the bond in question is a 10% bond but the yield to maturity has dropped to 9%, the price of the bond will be higher than the par value (also known as the face value). To further illustrate this example, if the time to maturity is 10 years and the par value of the bond is $1,000 the price of the bond can be calculated to be:

Present value of the interest payments: (n = 10, i = 9%)

=

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