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ACCOUNTS NUMERICALS MODULE A

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<YTM CALCULATION> <BONDS>

22. A 10%, 6-years bond, with face value of Rs. 1000 has been purchased by Mr. X for Rs. 900.
What is his YTM (Yield Till Maturity)?

Solution:

Given:

FV (Face Value) = 1000

CR (Coupon Rate) = 10%

So, Coupon = FV CR = 100

T (Time) = 6 years

R (YTM) = ?

I am going to solve the question using 4 methods / formulas.

1) YTM Formula 1 -

{Coupon + (Face Value - Market Value) Time} ( 0.36 X Face Value + 0.64 X Market Value)

Simple and Easy to use <USE IT TO GET EXACT YTM)

2) YTM Alternate Formula -

2 X {Coupon + (Face Value - Market Price) T} (Face Value + Market Price)

Simplest and Easiest to use <use it to get YTM very close to the exact value)

3) Trial & Error (or, Hit & Trial) Method -

Lengthy Method as solved in the book. (Avoid this method, but DO LEARN) <use to get fairly
correct YTM>

4) Using Cheat (using given 4 options in the exam)

Let's solve one by one using each method:

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1) YTM Formula 1
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YTM = {Coupon + (Face Value - Market Value) Time} ( 0.36 X Face Value + 0.64 X Market
Value)

= {100 + (1000 - 900) 6} (0.36 X 1000 + 0.64 X 900)

= (100 + 16.67) (360 + 576)

= 116.66 936

= 0.1246

= 12.46% Ans.

Note:

In above formula, 0.36 & 0.64 are Special Constants and this formula is well applicable in semi or
quarterly compounding too.

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VERIFICATION OF ABOVE FORMULA:

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Putting YTM = 12.46% or 0.1246 in Bond's Price formula gives a value equal to 900 (Which is
given market price). So, it proves 12.46% is the correct YTM. (We can verify if options not given,
and we have to calculate YTM).

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2) YTM Alternate Formula

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YTM = 2 X {Coupon + (Face Value - Market Price) T} (Face Value + Market Price)

= 2 X {100 + (1000 - 900) 6} (1000 + 900)

= 2 X (100 + 16.67) (1900)

= 233.333 1900

= 0.1228

= 12.28% Ans.

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VERIFICATION OF ABOVE FORMULA:

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Putting YTM = 12.28% or 0.1228 in Bond's Price formula gives a value equal to 907 (Which is
CLOSE to given market price). So, better avoid this formula too.

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3) Trial & Error (or, Hit & Trial) Method -

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OBSERVATION: Since Face Value (1000) > Bonds Price (900), it means YTM must be > Coupon
rate.

So, RULE HERE: To use trial and error method, we have to start with a value of YTM > Coupon
Rate and for each assumed YTM, we fill the YTM in bond's price formula and find the price until
we get a value < 900.

Since CR = 10%, and YTM must be > 10% (see observation), so,

Step 1:

If YTM = 11%, bond's price =957.69 (> 900, so keep guessing)

At 11% YTM, price comes 957.69 which is > given market price (900), so we have to assume
another value more than 11.

Step 2:

Let's YTM = 12%, bond's price = 917.78 (> 900, so keep guessing)

At 12% YTM, price comes 917.78 which is > given market price (900), so we have to assume
another value more than 12.

Step 3:

If YTM = 13%, price = 880.06 (< 900, so stop)

At 13% YTM, price comes 880.06 which is < given market price (900), so we have to STOP NOW.

Step 2 & Step 3 reveals that YTM must lie between 12% and 13%.

So, using INTERPOLATION TECHNIQUE,

YTM = 12 + (917.78 900) (917.78 880.06)

= 12 + 17.78 37.72
= 12.47% Ans

(Verification: Putting R = 12.47% in bonds price formula leads to value of 899.80 which is closest
to 900, so YTM = 12.47% is the right answer).

Now METHOD 4 and the Last One to find YTM.

4) Using Cheat (using given 4 options in the exam)

Simply fill one of the values from the options in bond's price formula and see, if the price comes
to 900, then that value is the correct YTM.

CONCLUSION:

Method 1 is Most Suitable if options are not given, & method 4 is most suitable if options given,
method 2 to just know approx YTM.

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