AC509: Financial Markets and Institutions

MMM

Guide on the Computation of Expected Rate of Return, Realized Rate of Return and Yield to Maturity
Basic Formula:
~ ~ ~ ~

P = CF1 + (1 + r)1

CF2 + CF3 + + CFn (1 + r)2 (1 + r)3 (1 + r)n

However, what may be asked for is not the present value of the bond but rather the expected rate of return or the realized rate of return or even the yield to maturity. So how exactly is the interest rate computed? There are two methods which may help you come up with the interest rate being asked for. 1. 60-40 Formula (commonly used to compute for YTM). 2. Interpolation 60-40 FORMULA Let us first discuss the easier formula using the example found in the book (by Saunders). You are considering the purchase of a $1,000 face value bond that pays 11 percent coupon interest per year, paid semiannually. The bond matures in 15 years and has a face value of $1,000. If the current market price of the bond is $931.176, the yield to maturity is? YTM= Annual interest + Par Price n 40%( par) + 60% (price) YTM = 1000(.11) + 1000- 931.176 15 (.40)(1000) + (.60)(931.176) YTM= 11.95% or 12% Or this formula can also be used to compute for err and rr. Such as this example. A bond you purchased 2 years ago for $890 is now selling for $925. The bond paid $100 per year in coupon interest on the last day of each year (the last payment made today). You intend to hold the bond for 4 more years and project that you will be able to sell it at the end of year 4 for $960. You also project that the bond will continue paying $100 in interest per year. Given the risk associated with the bond, its required rate of return (rrr) over the next four years is 11.25 percent. Let us simplify the problem: 2 years ago (year 2009)- $890 Selling Price NOW 2011- $925 Current Selling Price 4 years after (year 2015) - $ 960 Selling Price Interest- $100 on the last day of each year There are no limitations to the mind except those we acknowledge. -Napoleon Hill

AC509: Financial Markets and Institutions $890 2009 rr? $100 2010 $925 $100 2011 err?

MMM $960 $100 2015

$100 2012

$100 2013

$100 2014

rr= 100 + 925-890 2 (.40)(925) + (.60)(890) rr= 12.99% or 13% err= 100 + 960-925 4 (.40)(960) + (.60)(925) err= 11.58% As you may have noticed, there are very slight differences between the answers computed using the 6040 formula and the answers using the financial calculator (or the answers found in the book). That is why it would be helpful if you also learn how to interpolate to be able to compute for err, rr and YTM. INTERPOLATION ALWAYS KEEP THIS IN MIND: THE HIGHER THE INTEREST RATE, THE LOWER IS THE BOND VALUE. Thisll be handy to make your learning on interpolation easier. Still remember our discussion on this? We will use again the latter example found in the book. A bond you purchased 2 years ago for $890 is now selling for $925. The bond paid $100 per year in coupon interest on the last day of each year (the last payment made today). You intend to hold the bond for 4 more years and project that you will be able to sell it at the end of year 4 for $960. You also project that the bond will continue paying $100 in interest per year. Given the risk associated with the bond, its required rate of return (rrr) over the next four years is 11.25 percent. Let us simplify the problem: 2 years ago (year 2009)- $890 Selling Price NOW 2011- $925 Current Selling Price 4 years after (year 2015) - $ 960 Selling Price Interest- $100 on the last day of each year $890 2009 rr? $100 2010 $925 $100 2011 err? $960 $100 2015

$100 2012

$100 2013

$100 2014

There are no limitations to the mind except those we acknowledge. -Napoleon Hill

AC509: Financial Markets and Institutions Problem: WHAT IS THE EXPECTED RATE OF RETURN ON THIS INVESTMENT? Step 1: Plot the Low, Med and High interest rates with their respective bond value. LOW MED HIGH 11.25% err? 12% * $935.31 $925 $913.832*

MMM

Where did we get 12% and $913.832??? 12% is an assumption. Remember THE HIGHER THE INTEREST RATE, THE LOWER IS THE BOND VALUE? Since the given bond values are in descending order, it is but reasonable to assume that the bond value of the HIGHEST interest rate is LOWER than the bond value of the LOWEST interest rate. With this, we assume that the interest rate for the HIGH point is 12% based on the principle that THE HIGHER THE INTEREST RATE, THE LOWER IS THE BOND VALUE. You may ask, Miss, can we use any interest rate higher than 11.25%? Sure. You can even use 13% and still get the same answer. How was $913.832 computed? This is the bond value at 12% interest. Bond value= 100(3.0373) + 960(.6355) = 913.832 * Step 2: Get the difference between the bond value of the LOW and MED points, and the MED and HIGH points. Finally, add both differences. LOW MED HIGH 11.25% err? 12% * $935.31 $925 $913.832* 10.31 X 21.478 Z 11.168 Y

To avoid confusion in our computation later, let us assume: X= 10.31 Y= 11.168 Z= 21.478 Step 3: Now, we can interpolate using these formulae: err= L% + [( X / Z) x (H% - L%)] or err= H% - [( Y / Z) x (H% - L%)] Hence, using the LOW point info err= 11.25% + [( 10.31 / 21.478) x (12% - 11.25%)] err= 11.61% or using the HIGH point info err= 12% - [( 11.168 / 21.478) x (12% - 11.25%)] err= 11.61% Either way, youll get the same answer. There are no limitations to the mind except those we acknowledge. -Napoleon Hill

AC509: Financial Markets and Institutions How about if what is being asked is the REALIZED RATE OF RETURN?? Step 1: Plot the Low, Med and High interest rates with their respective bond value. LOW MED HIGH 12% * rr? 14% ** $906.41* $890 $876.45**

MMM

Where did we get 12%, $906.41, 14% and $876.4236??? 12% and 14% are assumptions. Remember THE HIGHER THE INTEREST RATE, THE LOWER IS THE BOND VALUE? The focal point in deriving such values is the $890 purchase price (of 2 years ago). To get the LOW point, we should be reminded that if the interest rate is low, the bond value should be high or in this case, higher than $890. Conversely, to get the HIGH point, if the interest rate is HIGH, the bond value should be low or specifically lower than $890. Therefore, make sure that when you come up with your assumed interest rates, the bond values are lower than the bond value or purchase price of the realized rate of return. How was $906.41 computed? This is the bond value at 12% interest. Also, use 2 years since this was purchased 2 years ago. Bond value= 100(1.69) + 925(.7972) = 906.41 * How was $876.45 computed? This is the bond value at 14% interest. Also, use 2 years since this was purchased 2 years ago. Bond value= 100(1.6467) + 925(.7695) = 876.45 ** Step 2: Get the difference between the bond value of the LOW and MED points, and the MED and HIGH points. Finally, add both differences. LOW MED HIGH 12% * rr? 14% ** $906.41* $890 $876.45** 16.91 X 30.46 Z 13.55 Y

To avoid confusion in our computation later, let us assume: X= 16.91 Y= 13.55 Z= 30.46 Step 3: Now, we can interpolate using these formulae: rr= L% + [( X / Z) x (H% - L%)] or rr= H% - [( Y / Z) x (H% - L%)] Hence, using the LOW point info rr= 12% + [( 16.91 / 30.46) x (14% - 12%)] rr= 13.11%

There are no limitations to the mind except those we acknowledge. -Napoleon Hill

AC509: Financial Markets and Institutions or using the HIGH point info rr= 14% - [( 13.55 / 30.46) x (14% - 12%)] rr= 13.11%

MMM

END

There are no limitations to the mind except those we acknowledge. -Napoleon Hill