Question

In: Finance

What are the total return, the current yield, and the capital gains yield for the discount...

What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)

Expert Solution

Total return means the return earned on bond during the lifetime of the bond. In the case of discounted bonds the total return is the sum of current yield and capital gains on the bond.

Total return = Current yield + Capital gains

Current yield refers to the interst earned on the price of the bond.

Current yeild = Annual interest payment / Current price of bond

Capital gains = Capital gains refers to change in bond price on the beginning price of the bond.

Capital gains = Change in bonds price / Beginning price of the bond.

In case of bonds Yeild to maturity ( YTM ) is the return on the bond therefore total return is equal to rhe YTM on bond i.e

Total return (r) = Yeild to maturity ( YTM)

Let us discuss an example.

Suppose a 10 year bond with 8% coupon is selling at 900 with a YTM of 11.05%

Current yield on the bond is = Annual interst payment / Bond price

interst payment = 1000 * 8% = 80

= 80 / 900 = 8.89%

Since YTM = Total return (r) hence.

YTM = Current yield + Capital gains

11.05 % = 8.89% + capital gains

Capital gains = 11.05% - 8.89 % = 2.16%

jeff jeffy answered 6 months ago

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