If the YTM equals the actual compound return an investor realizes on an investment in a coupon bond purchased at a premium to par, it is least likely that: A. cash flows will be paid as promised. B. the bond will not be sold at a capital loss. C. cash flows will be reinvested at theYTM rate. i didnt understand the above question. somebody help. what do u mean by purchasing a bond at ‘premium to par’…??
The YTM is a discount rate: the rate at which you discount the estimated cash flows to arrive at today’s price. The actual return that you earn on the bond investment may differ from the YTM if
- the actual cash flows are different from the estimated cash flows
- the rate at which you reinvest the cash flows differs from the YTM
Let’s look at the answer choices:
A. cash flows will be paid as primised: this is very likely: the YTM calculation was made based on the promised cash flows.
B. the bond will not be sold at a capital loss: selling at a capital loss might happen, and is likely if you buy the bond at a premium: the final cash flow is at par, so there will be a capital loss. This one says that the bond will _ not _ be sold at a loss, so that’s unlikely.
C. cash flows will be reinvested at the YTM rate: if you get all of the cash flows as promised, and reinvest at exactly the YTM, your actual return will be the YTM; if you reinvest at less than the YTM, your actual return will be lower than the YTM, and if you reinvest at more than the YTM, your actual return will be greater than the YTM; this is quite likely.
So, A’s likely, B is less likely, C’s likely: the answer’s B.