Yield Measures

Section: Yield Measures and the Term Structure Estimated study time: 45 minutes Content: Yield measures quantify the return characteristics of fixed income securities and provide the basis for pricing and comparing bonds. The yield to maturity (YTM) is the most commonly used measure — it is the IRR of the bond's cash flows, the single discount rate equating the present value of coupons and par to the current price. The bond equivalent yield (BEY) convention is used for U.S. bonds: for semiannual-pay bonds, the BEY = 2 × semiannual YTM. The effective annual yield (EAY) accounts for compounding: EAY = (1 + periodic rate)^m – 1, where m is the number of compounding periods per year. For semiannual bonds: EAY = (1 + YTM/2)^2 – 1. The money market yield (MMY or CD equivalent yield) and bank discount yield (BDY) are used for short-term instruments; they are not directly comparable to bond yields without conversion. The spot rate (zero-coupon rate) is the yield for a specific maturity assuming a single cash flow at that maturity. Spot rates are derived from the prices of zero-coupon bonds or stripped Treasury securities. The forward rate is the interest rate agreed today for a borrowing or lending that will begin at a future date. The relationship between spot rates and forward rates: (1 + S2)^2 = (1 + S1) × (1 + 1f1), where S1 and S2 are spot rates and 1f1 is the one-period forward rate one year from now. Forward rates implied by the spot curve reflect market expectations of future short-term rates (under the Pure Expectations Theory) plus potential risk premiums. Bootstrapping is the process of extracting spot rates from…