For a 6-month security that pays a coupon and face value at maturity, which of the following yield metrics would be the highest?
A. Bond-equivalent yield
B. Holding period yield
C. Effective annualized yield
The EAY.
Agreed
There is not enough information provided to answer this questiion.
(Those who have answered have assumed – probably unknowingly – that the return is positive. Whether it’s positive or negative is crucial to answering this question.)
Answer: Effective annualized yield
Let’s say the security costs 100 and pays 110 (100 face and 10 coupon) in 6 months. The holding period yield would be:
HPY = (P1 - P0 + D1) / P0 = (100 - 100 + 10) / 100 = 10%
The bond-equivalent yield though is simply twice the semi-annual holding period yield, or 20%.
The effective annual interest rate for this security would be the annualized holding period yield:
r = (1 + 0.1)^2 - 1 = 21%
Again, this assumes a positive yield.
Please redo your calculations when the yield is negative (or zero).
That’s a good point by S2000, but I think a positive yield would always be assumed. Otherwise, you’d just bury your money in your mattress.
I agree that that’s a common (even, perhaps, reasonable) assumption. But I think that greater understanding is gained by understanding that assumption, and seeing what happens when it’s false.
^You’re absolutely right. Bringing that fact to life makes you think about the question a little harder, and it helps you understand the answer.
And this, my L1 and L2 friends, is why you should strive to answer the essay questions in the curriculum. It activates your brain much more than simply picking A, B, or C.
_ A _ – if I may be so bold – _ men! _