Hello guys, Apparetly, I’m facing a great problem in understanding the concept of “Yield” … i will try to simplify it. let’s say that, 5 year treasury yields are 6% , and the yields of a 5 year ABC inc, corporate is 7.3%. here i’m asking what does “yield” mean? a friend of mine told that yield is the interest, but i’m not convinced with his opinion.
Well . . . there is current yield, and cash flow yield, and yield to maturity, and yield to call, and yield to put, and yield to worst, and . . . .
And those yields can be effective annual yields, or bond equivalent yields, or nominal yields, or . . . .
That’s the problem with using imprecise language (which finance people tend to do frequently): nobody is quite sure what someone else means when they use the same word.
In practice, most people (not all, alas) mean “(bond-equivalent) yield to maturity” when they say, merely, “yield”. Thus, your friend is most likely wrong; it’s not just interest, but interest plus any amortized gain or loss on the principal.
But that’s only usually; it’s not universally.
S2000magician is, of course, correct, but I think it helps to simplify, just to get a basic grasp, and then learn the concepts academically from the curriculum. Yield is the hypothetical amount of cash you receive from a security, based on the price you bought it at. I’d differentiate it at a fundamental level from the coupon. So a $5 coupon on a bond you bought for $90 is a yield of 5.56% (=5/90). Coupon is a dollar amount, yield is a percentage. Yield is different than interest because interest generally is a percentage based on the original price/face value of the product, whereas yield is based on purchase price. Also note that yield and price move in opposite directions, which probably among the most important fundamental concepts in finance. This can be explained a few ways, one being that, simply put, if you increase price in the above yield calculation equation (increase the denominator), the yield goes down: $5 coupon / $90 purchase price = 5.56% yield $5 coupon / $100 purchase price = 5% yield (price went up, yield went down) $5 coupon / $80 purchase price = 6.25% yield (price went down, yield went up) The actual “why” of this is another subject, and relates to the price of similar instruments, e.g. on-the-run T-bonds or corporate bonds from comparable companies. Yield reflects prevailing rates, and efficient markets won’t overpay for a given coupon.
It’s important to note that these are calculations of current yield, not yield to maturity.
S2000magician, I have another question :
I know that " Treasury Yield Curve : is actually different from " Term Structure of Interest Rates", but these two terms are frequently used interchangeably in the CFAI curriculum. I am very much confused by this. Can you explain why ?
It ain’t what you don’t know that hurts you; it’s what you know for sure that just ain’t so.
(Attributed variously to Mark Twain, Will Rigers, Satchel Paige, Yogi Berra, and Josh Billings (Henry Wheeler Shaw).)
They’re not, actually, different from each other.
But why they can be used interchangeably ?
Sorry, do you mean that “they are not actually different from each other” and “they are actually same” ?
Yup.
Very sorry, I am now even more confused. My understanding is that the definitions (as follows) of these two terms are actually different.
Treasury Yield Curve : The relationship between the yields ( YTMs ) of the on-the-run Treasury coupon bonds and their maturities.
Term strucure of interest rates : The relationship between the (actual / theoretical) spot rates on Treasury zero coupon bonds.
Can you advise me why they are actually same ? And please correct me if above definitions are wrong !
There are, broadly, three Treasury yield curves:
- Par Curve : at each maturity, the coupon rate that a (coupon-paying) bond must pay to be priced at par. The par curve gives the yield to maturity on coupon-paying bonds.
- Spot Curve : at each maturity, the discount rate for a single payment at that maturity, discounting it back to the present. The spot curve gives the yield to maturity on zero-coupon bonds, and is derived from the par curve by bootstrapping.
- Forward Curve : at each maturity, the discount rate for a single payment at that maturity, discounting it back one period. The forward curve gives single-period discount rates (yields) on zero-coupon bonds, and is derived from the spot curve.
Thus, when you refer to “the Treasury Yield Curve”, you could be talking about any of these three, though the par curve is the most common. Because there is a one-to-one relationship between the par curves and spot curves (given a par curve there is a unique spot curve; given a spot curve there is a unique par curve), a one-to-one relationship between spot curves and forward curves, and (thus) a one-to-one relationship between par curves and forward curves, any one of these is sufficient to describe the other two uniquely.
The phrase “term structure of interest rates” generally refers to the spot curve, but, because of the one-to-one relationships, it also refers to the par curve and to the forward curve.
I hope that this helps.
S2000magician,
Thank you so much for your explanations. However, please refer to CFAI 2013 L1 curriculum Vol 5
P.410 : The 1st paragraph under the title of 3.2 The Treasury Yield Curve
P.412 : The last 2 paragraphs
P.415 : The last 2 paragraphs
My confusions are resulted from these statements ! Thanks !
My pleasure.
Alas, I haven’t a copy of the 2013 curriculum. If you’d like, you can e-mail me at bill@bottomlinegurus.com; that way, we don’t run the risk of any copyright problems for AnalystForum.
Sent to you !
Got it.
They’re using “Treasury yield curve” to mean the Treasury par curve, and “term structure of interest rates” to mean the Treasury spot curve.
Different curves, but inexorably linked.
Got it.
They’re using “Treasury yield curve” to mean the Treasury par curve, and “term structure of interest rates” to mean the Treasury spot curve.
Different curves, but inexorably linked.
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Now I am sure they are different curves but are used interchageably !!! Thanks again !!!