YTM compounding

CFA Level I
#1

Hi everyone

I’m having a bit of trouble with the YTM, specifically with the reinvestment assumption. According to the CFA curriculum and to Investopedia the coupons are reinvested at the YTM. According to Wikipedia:

Contrary to popular belief, including concepts often cited in advanced financial literature, Yield to maturity does NOT depend upon a reinvestment of coupon payments. Yield to maturity, rather, is simply the discount rate at which the sum of all future cash flows from the bond (coupons and principal) is equal to the price of the bond.

After having read the paper quoted in Wikipedia it looks to me like Wikipedia is actually right.

What do you think? I guess you simply take the CFA definition even if it is wrong for the exam?

Thanks for the help!

#2

Yield to maturity is nothing more than an internal rate of return (IRR) for the bond investment.

The proper way to incorporate the reinvestment assumption is this:

If the reinvestment rate is less than the YTM, then the realized yield (for the _ entire _ investment: the bond, the coupons, and the reinvestment interest) will be less than the YTM.

If the reinvestment rate is equal to the YTM, then the realized yield will equal to the YTM.

If the reinvestment rate is greater than the YTM, then the realized yield will be greater than the YTM.

#3

Thanks a lot! That clarifies the issue.

#4

My pleasure.