idk why this doesn't make sense to me.
If a bond costs $1000 and gives 10% cash flows a year (100 a year) and you hold for 10 years, what is your IRR? it is clearly 10% because that's your interest rate
However if looking at the IRR formula we take the (new value / old value) ^ (1/10) -1 then we get something like 7%... what am I missing here?
(1000 face value + 1000 cashflow value ) / 1000 (cost) ^(1/10)-1
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Your formula assumes the interest is being compounded. That’s actually the CAGR formula (compounded annual growth rate).
CAGR: $1000 turns into $2000 in 10 years if it grows by 7% a year. So…
1000
1070=1000*1.07
1145=1070*1.07
…
2000
That’s not actually what’s happening in this situation. The interest does not become apart of the principal.
Follow-on, I think YTM is much easier way to conceptually think about fixed income stuff.
Yield-To-Maturity
=Interest Return + Price Appreciation return
=APR + CAGR between current market Price & Face Value over remaining maturity
In this case the Bond is generating 10% APR and assume a face value = market price (no price appreciation). So YTM is just 10%.
Makes sense, thanks
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