Question

Investigating the principle that all bonds are priced to give the same total yield which is the current market rate of interest. REQUIRED: Create your own bond – i.e. the par value may be kept at 1000, but decide your own coupon rate, maturity period and current market rate of interest. Now compute your total yield which should consist of Current Yield plus Capital Gain/Loss Yield and find out if it equates the market rate of interest that you selected.

Answer 1

Consider a bond with following charecteristics:
Face value = $1,000
Coupon rate = 10%, payable annually
Maturity = 5 years
Market rate = 12%
The price of the bond will be the PV of the expected cash flows from
the bond when discounted at 12%. The expected cash flows are the
maturity value [face value] of $1,000 and the 5 yearly interest income
of $100.
So, the price of the bond = 1000/1.12^5+100*(1.12^5-1)/(0.12*1.12^5) =	$             927.90
Now suppose the bond is held till maturity and the market interest rate
remains the same, the price at the end of the first year would be:
Price of the bond = 1000/1.12^4+100*(1.12^4-1)/(0.12*1.12^4) =	$             939.25
Now the returns from the bond for the year it was held would be the sum
of the following returns:
Current yield = Interest received/Beginning price = 100/927.90 =	10.78%
Capital gains yield = Ending price/Beginning price-1 = 939.25/927.90-1 =	1.22%
Total yield = Current yield+Capital gains yield = 10.78%+1.22% =	12.00%
Thus, for a bond the total yield is the sum of the current yield and the
capital gains yield.