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Subject 1. Sources of Return PDF Download
There are three sources of return on a fixed-rate bond:
Harshal Shahe purchases a bond, but isn't sure how much of his total return will come from reinvested interest compared to coupon interest and capital gain. What is the total reinvested interest (i.e., interest on interest) that Herschel earns, assuming a price of $941.12, coupon of 15.00%, 18.5 year maturity and a market interest rate of 16.00%?
First calculate total future cash flows: PV x (1+r)N = Price of bond of $941.12 x (1 + Market Interest rate 16.00% divided by 2)37 = $16,230.27
less initial purchase price = $941.12
less coupon interest payments = 15.00% * $1000 * 18.50 = $2,775.00
less capital gain (add capital loss) = $1000 - $941.12 = $58.88
The yield-to-maturity measures an investor's return from the bond correctly only if these assumptions are true:
- The bond is held to maturity.
- The coupon reinvestment rate is the same as the YTM.
- The issuer does not default.
The total return is the sum of:
- the future value of reinvested coupon payments.
- the sale price, or redemption of principal if the bond is held to maturity.
There are two types of interest rate related risks:
These risks offset each other to a certain extent. Which one dominates depends on the bondholder's investment horizon. The shorter the investment horizon, the smaller the coupon reinvestment risk, but the bigger the market price risk.
User Contributed Comments 5
|Haag||Shorter horizon = smaller reinvestment risk but bogger market price risk|
|tomalot||I prefer the term culchie|
|AggelosAnd||Why 15% * 1000 * 18.5 instead of 15% * 1000 * 37? The coupon is annual?|
|nmech1984||ok then. (15%/2) * 1000 * (18.5*2)|
|nmech1984||Aggele to epiases?! :)|
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