Aprox YTM Formula?
Hi all,
Wondering if someone can help explain the intuition behind this formula for aprox YTM: (((Coupon + ((Par-Price)/years to maturity))) / (Avg. of Price and par)
Top part makes sense (getting certain coupon + capital return each year), but a little unclear on the intuition for taking average in denominator. Seems to work pretty well. Thanks!
Comments (9)
Following--YTM Formula
The price of a bond moves closer to par value as it approaches maturity. So the denominator of your formula just takes the average of the current price and the price at maturity
Thanks for the reply - I get that, but why does using that better approximate your return? Intuitively, I would think your return is based on the capital you put in originally (i.e., bond trades at 80 why do you divide by the midpoint instead of the price you actually buy in at)
Think about it like this. The yield to maturity will change dependent on the time to maturity of the bond, obviously. The bond price will get closer to par as the maturity gets closer. So it uses essentially an average price over the course of the bond's life - ie if the bond is trading at 80 and matures in a year, the 'average price' over that year will be something like 90.
As the bond approaches maturity, does the price move in a linear fashion?
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Learn moreNot necessarily but linearity is best assumption unless you know what convexity
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Do credit HFs actually use this formula or is this more for RX banking?
It's back of envelope math. Credit HF will use a yield calculation from bloomberg for bonds/loans.
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