Introduction to Law and to Finance

Unit 6 Introduction to Finance

Returns, Time and Risk

Contents
6.1
Introduction

3

6.2
Returns, Time and Risk

4

6.3
Returns and the Price of Financial Securities

10

6.4
Compound Interest

17

6.5
Discounting and the Yield to Maturity

25

6.6
Returns on Equities

27

6.7
Crunching the Numbers

33

6.8
Conclusion

35

References and Websites

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Introduction to Law and to Finance

Unit Content
Unit 6, 7 and 8 introduce the basic elements of financial theory. Unit 6
introduces the concept of returns on financial securities, and, in particular,
the reward for time. The unit examines the relationship between the return
on a security and the market price for the security, and explains this relationship in detail using a simple bond and US Treasury Notes as examples.
The unit then introduces and explains compound interest, discounting, and
the yield to maturity, for bonds which pay out an income stream over a
number of time periods. The unit also analyses the returns on equities.

Learning Outcomes
After studying this unit you will be able to:
understand the relationship between financial law and finance theory
explain the relationship between the return on a financial security and
the price of the security
calculate return (current yield) and yield to maturity on a simple oneyear bond
interpret and explain market data on yields to maturity for bonds
understand and apply compound interest
understand and apply discounting
explain the yield to maturity for a bond which pays a stream of
coupon payments over time
calculate and interpret return on equities

Readings for Unit 6

There are no external readings for this unit.

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Unit 6 Introduction to Finance Returns, Time and Risk

6.1 Introduction
The legal principles you have studied in Units 1 through 5 are one set of
foundations upon which modern financial systems rest. Another foundation
is the large body of financial theory. It enables the banks, traders, firms and
individual savers and investors that rely on financial markets to make
decisions based upon the valuation of assets. In Units 6 through 8 we
introduce you to the basic elements of financial theory and to their uses.
Financial law and financial theory are related. Let us give an illustration of
their relation.
A financial security, such as a corporate bond, which is traded in financial
markets, is a contract between the owner of the bond and the company that
issued it. For example, the contract obliges the company to make specified
interest payments and satisfy other conditions. Therefore, lawyers are
concerned with its standing in contract law. But because the bond is traded
in markets, financial analysts are concerned with its market price, or the
relation between its price and its underlying value. Financial theory establishes basic principles and tools for analysing the factors that determine the
bonds market price and the price fluctuations that result from market
demand and supply.
The bonds market price is related to the legal obligations specified in the
contract (such as the interest payments to be made and the maturity of the
bond the length of time before the borrower must repay to the bondholder
the amount of the loan, the capital value, represented by the bond).
It is also related to the markets assessment of risks including the risk that
the contract will not be honoured and of what legal remedies will be available. The borrower might default or, in other words, fail to make a
contractual payment of interest or repayment of capital to the bondholder,
and the bondholder will seek the protection of contract law and, possibly,
insolvency law.
So financial theory is related to legal aspects of the bond, and we can also
say that the legal aspects are related to financial theory: the investment
bankers who designed the bond chose legal features (interest payments,
maturity and other features) that they thought would be most attractive to
investors in the market conditions that existed at the time of issuing the
bond.
Although financial theory is connected in those ways to the law that underpins finance, they have different roots and have developed separately.
Consequently they use different methods of reasoning and analysis. The
types of reasoning you used in studying Units 1 through 5 legal reasoning
are different from the types of reasoning you will use in Units 6 though 8
finance theory reasoning. They are not incompatible; many court judgments
rest on valuations derived from the basic principles of finance. But the
methods and techniques of reasoning are different.
Financial theory has its roots in models which are formulated and solved
mathematically and it employs concepts and techniques derived from
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Introduction to Law and to Finance

statistical theory. In Units 6 through 8 we will introduce you to some of the

basic ideas in financial theory. We will explain them in words and, where
necessary, we will also show how they can be formulated using elementary
maths and statistics. And we will help you use these ideas and techniques to
think about financial issues yourself.

6.2 Returns, Time and Risk

As a first step, we would like you to re-read the passage you read in the
Introduction to this course, titled Introducing Financial Markets and Financial Law and located at the front of the material for Unit 1. In Section 2 of
that Introduction we explored the links between finance and financial law
by focusing on finance as a promise and outlining the relationship between
three elements
returns
time
risk
In Unit 6 and in Units 7 and 8 you will study in more depth the meaning of
returns, time and risk, and their interrelation. To give you a firm foundation
for that study, please re-read the Introduction reproduced here as Finance
and Promises.

Finance and Promises1

The fundamental element of all finance is a promise: funds are transferred
between parties on the basis of a promise. The recipient promises to pay to
the supplier of funds an amount sufficient to cover the initial investment
and to pay a return (profit or yield) to compensate the investor for two
things:
a willingness to undertake the risk involved, and
their patience in foregoing the use of the principal for a period of time.
It is not difficult to see the fragility of those promises and necessarily the
fragility of the relationships underlying financial markets. Some people
cheat and lie. Others have no intention of keeping their promises. Some
people forget and most people are not always capable of discharging the
promised obligations even if they honestly intend to. Records are lost and
promises once given are forgotten. All people die. Few people trust wholeheartedly what they are told. Most people, particularly bankers, want some
sort of assurances that promises are kept.
But promises are difficult to value. Dishonest people have no intention of
sticking to them, which makes them more likely to promise a lot. Even
honest people behave oddly under the pressure of too much debt. Banks and

Reproduced from the Course Introduction: Introducing Financial Markets and Financial
Law.
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Unit 6 Introduction to Finance Returns, Time and Risk

other financial firms as gatekeepers in the flow of funds have therefore every
reason to be suspicious. Financial markets rely on good promises. This is
obvious and reasonable but on close inspection it tends to advantage the
dishonest with very serious implications for access to finance. Unless banks
and other sources of finance such as insurance companies, institutional
investors or ordinary stock holders have trust and confidence that the
promises will be kept, they are unlikely to part with their money.
Trust in the value of promises is based on personal experience. People tend
to trust individuals whom they know, and know that they will pay. Unless
law recognises and protects promises, financial intermediaries such as banks
and investors will only provide funds on the basis of personal experience
and trust, normally confined to close friends, family, political and business
acquaintances and very wealthy people who can reassure others that they
will pay back. The entire financial system would collapse under the uncertainty caused in the absence of legal institutions.
Poor people do not tend to have wealthy friends and therefore financial
markets operating on the basis of personal connections are grossly unfair for
ordinary people. They raise barriers to finance opportunities and prevent
bright individuals from realising their potential.
In major financial markets the promises involved in finance usually take the
form of a written contract. Those contracts take the form of specific financial
securities such as bonds, bills, loans, equities or derivatives, with terms and
conditions in supporting documents. And those contracts are traded on
financial markets, as when equities are traded on stock markets.
To fix those ideas, consider how these common forms of finance encapsulate
a promise:
A simple bond issued by a corporation, government or other body is a
contract where, in return for a loan, the bond issuer promises to repay
the principal at a named date and to pay interest of a fixed amount on
certain dates. (There may also be other rights and obligations
contracted by the bond holder and issuer.)
A bank loan is where the borrower promises to repay the principal
and to pay interest (at a fixed or variable rate) in the future. A bank
deposit is similar in that the owner lends money to the bank in return
for a promise that interest will be paid and the principal will be paid (a
withdrawal honoured) under certain conditions.
An equity (a share or stock), when issued, involves the buyer putting
money into the issuing company in return for a promise that he or she
has a share in the current and future value of the company,
determined by potential future profits. If the companys stock is listed
on a stock exchange it also involves a promise that his or her share is
marketable on the exchange.
Derivatives, such as call options, are also promises that take the form
of a contract. In return for paying a premium, the owner has rights
promised to him or her the right, but not the obligation, to buy the
underlying security in the future at a price specified in the derivative
contract.

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Introduction to Law and to Finance

Returns, time and risk

We hope you can see why we say that the fundamental element of all
finance involves a promise. Focusing on the idea that all finance involves a
promise enables us to see why finance people and financial lawyers focus
attention on three universal concepts of finance:
returns
time
risk.
In this section we wish to explore a bit further the relation between the
promise in finance (or its form as a contract), and returns, time and risk.
We hope that by exploring returns, time and risk, you will also solve the
puzzle:
What is the connection between the law subjects you have studied in
Units 1 through 5 of this course and the concepts and tools of finance
that you will study in Units 6 through 8?
The puzzle arises because in peoples minds the basic elements of law are
not usually associated with basic mathematical and statistical concepts. The
very appearance of the units dealing with each is different, for the law units
are wordy while the units on basic quantitative financial tools use symbols
and equations. Enabling you to understand the connection between the units
of this course that deal with law and the units that deal with quantitative
financial tools is the main objective of this section.
The answer to the puzzle is that in finance both sets of concepts basic legal
concepts and finance ideas enable us to deal with the returns, the time
element, and the risk element of finance.

Returns
Finance involves a transfer of funds with a promise to repay and to meet
other conditions, and in capitalist markets the funds will only be provided if
the recipients promise enables the provider of funds to expect a profit. The
expected profit on the investment, its expected return or yield to the investor, is measured as a percentage rate of return per year (or over some other
period).
The return can take several forms, but the most common are interest (on
bonds, bills, and deposits), dividends (paid on a companys shares), and
capital gains (increases in the price of marketable securities). In some finance, such as Islamic finance, interest is not permitted, but other forms of
return are.
The expectation of a return is based on the promise or contract involved in
the provision of finance although the promise does not itself specify the
return that can be expected. A fixed interest bond, bill or deposit does
include the payment of a return on the original investment at a fixed rate.
But a firm that raises money from a variable-rate loan only contracts to
determine the interest rate variations according to particular rules, instead of
fixing the return. A firm that raises money by issuing new equities, common
stock, makes a contract which entitles the shareholder to a share of the
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Unit 6 Introduction to Finance Returns, Time and Risk

companys value; it does not guarantee that dividend payments will be

made at any positive rate but the firm does effectively promise to provide
information to enable the shareholder to form an expectation about the
profit on his or her investment in the share.
The law provides mechanisms to support and enforce the promises made in
finance. Finance rests upon the ability to quantify the returns on finance, for
financial decisions require people to be able to judge and compare returns
with exact tools.
The return on finance is a reward for transferring the funds, but why should
a reward be necessary?
One reason is because of time the investor foregoes the use of the money
for a period of time, and requires a reward as compensation. The other
reason is risk the investor faces the risk that the recipient will not keep the
promise to pay, and requires a reward to compensate for the risk. Additionally, the investor faces other risks and a return is required to compensate for
all perceived risk.
The returns on a financial security are reducible to the return due to time
plus the return due to risk, and the distinction between the two components
is fundamental to many of the innovations in financial markets. A riskless
security (commonly defined as government bonds issued by the US Treasury or the UK) is assumed to pay a return that reflects only time.

Time
The reward for time has two rationales.
First, when economists think how an isolated individual would behave they
assume that individuals innately have impatience: people would prefer $100
today rather than the certain promise that they will receive $100 one year
later.
Perhaps a certain promise of $100 + $5 (= $105) after one year would be as
desirable as $100 today. In that case, their impatience could be described as a
time preference rate of 5 per cent per year ($5 as a percentage of the principal $100).
The second rationale is of more practical relevance to individuals, banks or
firms operating in the context of well-developed financial markets. If money
is invested for a period of time, a return is required because the investor is
foregoing alternative uses that would have compensated for the time the
money is tied up. If, for example, it is invested in a corporate bond for a
year, the investor expects to be compensated for the fact that he or she could
have invested in a risk-free US Treasury bond for that period. The return on
the US Treasury bond is the opportunity cost of investing in the corporate
bond for that period of time. If the Treasury yield is 5 per cent per annum,
that is a measure of the opportunity cost of time for which the investor
must be compensated.
The law recognises the value of time, and the requirement for a reward for
time, both in Contract Law and in quantifying payments of damages for
torts.

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Introduction to Law and to Finance

The financial techniques you study in this course are the basis for such
calculations, whether by courts or in the normal process of valuing financial
securities.
The main tools that you will study in Unit 6 are the principles that enable us
to calculate compound interest. Here, too, we show how to use the techniques for calculating the net present value of future returns. In the example
we have used here, the impatient individual attaches a present value of
$100 to a future sum of $105, but finance uses simple quantitative techniques
to calculate the present value of more complex streams of future income.

Risk
Arguably, the most important activity of financial markets is their ability to
trade in risk. That enables firms and individuals to manage risk and, for that
to happen, markets set a price for risk. Finance encounters several types of
risk and financial markets have developed the ability to trade in and manage
many of them. Both law and the techniques of financial analysis are the
foundations for that process, and each has particular roles.
Law is the main (but not the only) instrument for controlling the risk that a
lender might suffer due to the possibility that the borrower, or the managers
of the borrowing firm, will commit fraud or that the borrower or an intermediary acts with negligence. The law of torts, which you have already
studied in this course, is the basis for compensation in respect of such
behaviour. Even if there is no fraud or negligence, a borrower might default
on a loan because of the risks of operating its business in fluctuating markets. If that default involves insolvency (bankruptcy), the law provides the
framework for dealing with the conflicts of interest between all the different
types of creditor.
However, those roles for the law come into play after the risk has been
realised: the possible bad event has occurred. The concept of risk as a
component of the return on finance is forward looking. It deals with the
degree of probability with which bad outcomes will occur over the life of the
investment.
The law has a role in reducing risk in that forward looking sense, for investors who know that the law will efficiently judge and punish fraud believe
that it will deter fraud and therefore reduce the risk of it. Similarly, the belief
that there is an efficient bankruptcy law which will enable bad outcomes to
be dealt with fairly and at minimum cost enables lenders to calculate that
the cost of a risky future is lower than if there were no such law.
Another example of the role of law in overcoming risk is that appropriate
laws and an efficient judicial system can enable lenders to lend against
collateral, which reduces their risk. We can illustrate the importance of law
in that context by comparing different countries.
Consider the value of land as security for loans. Most countries in the world
recognise the value of property rights as collateral. It is true that the notion
that someone may lose his or her home because of failure to repay debt to a
faceless multinational bank is distasteful, but on closer inspection it has
nothing to do with the cruelty of individuals. It goes back to the inherent

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Unit 6 Introduction to Finance Returns, Time and Risk

fragility of promises and the need to reassure investors and financiers that
the debtor has incentives to keep to his or her word.
With regard to the importance of property rights and enforcement mechanisms for the functioning of financial markets, study after study has shown
that in jurisdictions where it is easier for the financier to seize collateral, the
more lending takes place. In England, for example, it takes one year on
average at a cost of 5% of the value of the house to repossess a house from a
defaulting borrower. Mortgage loans amount to a staggering 52% of total
income (GDP). In Italy, with similar per capita income, it takes on average
four years and 20% of the value of the house in legal costs and lawyers fees
to repossess a house upon default. The value of home loans in Italy is 5% of
GDP, only one tenth of the relative value of home loans in England. The
high cost of enforcement and the relatively poor quality of the judicial
system, demonstrated by the delays and the prohibitive legal expenses of the
legal system, affect the cost of loans and prevent the flow of funding to those
who need it most (statistics from Bianco, Jappelli and Pagano, 2002).
The risks of fraud, default or bankruptcy refer to large singular events. The
risks that are the core of financial markets everyday business arise from the
continuous volatility of financial markets themselves. An investor in the
shares of a company, for example, faces the risk that the future price of the
share, determined by market demand and supply, will fluctuate widely.
Even if the future trend of the price is upward at a rate that gives a positive
return, as capital gains, adequate to compensate for time, large fluctuations
of the daily price around that trend create the risk that the capital gain will
not be realised when the share is sold. To compensate for that risk, the
expected rate of return would have to be higher than the compensation for
time: there has to be a risk margin, risk premium, or spread over the riskfree return for time.
In Unit 7 we use concepts of frequency, probability, and chance to help us
understand risk and how financial markets generate a price for risk. Those
risks might be the risks that result from the continuous volatility of market
prices, or the risk of the large singular events we discussed before. Both
types of risk are priced by financial analysts. Insurance companies, for
example, are able to calculate the premium (price) for an insurance policy
against fraud or negligence; the price of credit derivatives concerns the
probability of a borrowers default; and using the probability of default or
insolvency, the credit rating agencies (such as Standard and Poors) give
ratings to companies which determine the risk premium that lenders require
on bonds and derivatives. It became evident in the financial crash of 2008
that the ways those tools had been used by banks and credit rating agencies
in the preceding boom (or speculative bubble) were seriously flawed, but the
basics remain valid even though we need to be careful about how they are
applied.

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6.3 Returns and the Price of Financial Securities

From the previous sections you should now be familiar with three concepts:
Finance involves a contract. The contract is often known as a financial
security.
The return on a financial security is related to time. It is a reward for
investing for a period of time.
The return on a financial security is related to risk. It is a reward for
bearing the risk associated with the security.
In Unit 6 we explain a key fact of financial securities:
There is an inverse relationship between the return on a security and the securitys
market price.
In the simplest form of the relationship, if the market price of a security falls,
the return that can be obtained by investing in it increases. If the market price
rises, the securitys return decreases.

 Review Question
Please pause and think about that fact.
Is it surprising? It is a fundamental characteristic of financial markets and you can
observe it in financial markets as securities market prices change. Because it is
fundamental we would like you to be sure that you understand it, so in the following
paragraphs we will explain it carefully.
The inverse relationship between the return from a security and the securitys market price does not result from some complex market behaviour
by buyers and sellers. It is a purely mechanical relationship that follows
from the definition of a securitys return. Therefore studying it helps you to
understand the meaning of returns.
Using bonds as our first examples of financial securities we would like
you to keep two questions in your mind throughout the following pages.
We will ask you for your answers, and provide our own, at the end of
section 6.5:
Question 1: why is a bonds yield inversely related to its price?
Question 2: what is the connection between the return on a bond and
the value (or price) of time?

6.3.1 A simple example

Let us explore the relationship with a simple hypothetical example one of
the simplest. Even though the example is highly simplified, it illustrates
three concepts of the return on a bond:
the bonds coupon interest rate (or coupon rate)
the bonds current yield
the bonds yield to maturity (or yield),

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Unit 6 Introduction to Finance Returns, Time and Risk

 Review Question
By the end of Section 6.3 you should be able to answer the question: which measure of a
bonds return is inversely related to its price, the coupon rate or the yield?
Assume that a government issues a bond with a value of $100 per unit. That
value is the par value per unit. We assume the government also sells the
bond at a price equal to par value ($100) initially.
The maturity (or term) of the bond is one year; it is known as a one-year
bond. That means that the borrower the government promises to repay
the person who bought the bond (or a subsequent owner) $100 per unit 365
days after it was issued.
The borrower also promises to pay the owner of the bond a fixed amount,
$10, in interest one year after issue. Because the amount of that interest
payment is fixed, the bond is known as a fixed-income security (it is one of
many types of fixed income securities).
The interest payment is known as the coupon. The coupon payment is an
amount of money ten dollars in this case. But knowing the amount of the
coupon is not very useful; a more useful measure is the coupon interest rate,
which expresses the coupon amount as a percentage of the par value of the
bond.

 Review Question
What is the coupon interest rate in the example we are using?
The coupon amount is $10 per year (we say, per annum, or, abbreviated, pa).
The par value of the bond is $100. Therefore the coupon interest rate per
year is

10
$10 pa

100 =

100 pa = 10% pa
100
$100
Now let us see how the return on that one-year bond is inversely related to
its price.
Suppose that when the government issues the bond, which has a par value
of $100 and a coupon of $10 per annum, it sells it for $50. The coupon of $10
would then represent a yield of 20% pa in interest alone (that is called the
current yield). That is because the coupon is 20 per cent of the lower price:

10
10 pa

100 =

100 pa = 20% pa
50
$50
Interest is one part of the return. Another part is the gain the capital gain
that the buyer will receive when the bond matures, for she bought it at $50
and receives the par value of $100 when it matures after one year.
Over one year the total return on a $50 investment in the bond is:

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coupon + gain 10 + 50
=

100 = 120% pa
50
price
That total return, which includes the interest received and the gain made
when the bond is redeemed, is the yield to maturity of this one-year bond.
It is often referred to simply as the yield. The yield to maturity is the main
measure of a bonds yield referred to by analysts, traders, and investors in
financial markets. We refer to it throughout this unit and you will study it in
detail in Sections 6.3 to 6.5.
The conclusion is that a reduction in the market price of the bond increases
the current yield over the year from 10% to 20% and the total market return
(yield to maturity) from 10% to 120%. It is an example of the general principle that the return is inversely related to the price.
We have used an unrealistic example to illustrate the inverse relation
between a bonds price and its return. It is unrealistic because it would be
unusual for a government to discover that it can only find buyers for a new
bond with par value of $100 if it discounts the price to $50; it would be more
normal in such circumstances for the government to decide in advance that
it will pay a coupon rate higher than 10% and therefore be able to sell at a
price closer to $100. And only in a fictional economy (or one experiencing
extremely high inflation) would buyers require a total return of 120% pa and
therefore only buy at a price low enough to produce that.
But, in reality, the process of selling government bonds does enable the
market to adjust the selling price of any particular bond until its total return
is adjusted to a level that buyers require. One method that governments
used for issuing bonds in a way that facilitates that adjustment is to sell
them by auction.

6.3.2 A realistic example US Treasury

Auctions are used by the US Treasury, for example. It has to finance the
deficit of the US government plus its redemption of maturing bonds. It
issues bonds by selling them in an auction.
Basic Definitions
Now, before proceeding, let us be clear about terminology.
So far we have used the word bond as a general term for any contract issued by a
government, corporation or other organisation under which the issuer promises to pay
interest to the bondholder and to redeem the bond at par value on a certain date. Usually
the bond is marketable so that the original purchaser can sell it and it can be resold
before maturity.
The general name bond is equivalent to other general names in the language of
financiers. For example government bonds may be referred to generally as government
debt or government paper.
Since there are many different types of bonds, each with its own special features, such
general words are used side by side with specific names for different types of bonds.
Different types bear different names according to their characteristics. The US Treasury
gives distinct names to three of its main types of bonds:

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Unit 6 Introduction to Finance Returns, Time and Risk

Treasury Bills: are issued with a short maturity. Some have a redemption date 4
weeks after issue, some 13 weeks, some 26 weeks and some one year (52 weeks)
after issue. Their coupon rate is zero, so the return is the capital gain that the
investor makes by buying them at a discount below par value.

Treasury Notes: are issued with maturities of 2, 3, 5, 7, and 10 years. They have a
set coupon rate and pay interest every six months until they mature.

Treasury Bonds: are issued with a maturity of 30 years. They have a set coupon rate
and pay interest every six months until they mature.
Now let us illustrate the inverse relationship between the price of a bond
and its return with the realistic example of a ten-year Treasury Note. It is
best to read the explanation given by the US Treasury itself; here is the
explanation on their website TreasuryDirect:
Treasury Notes: Rates & Terms
Notes are issued in terms of 2, 3, 5, 7, and 10 years, and are offered in multiples of $100.
Price and Interest
The price and interest rate of a Note are determined at auction. The price may be greater
than, less than, or equal to the Notes par amount. (See prices and interest rates in recent
auctions.)
The price of a fixed rate security depends on its yield to maturity and the interest rate. If
the yield to maturity (YTM) is greater than the interest rate, the price will be less than par
value; if the YTM is equal to the interest rate, the price will be equal to par; if the YTM is
less than the interest rate, the price will be greater than par.
Here are some hypothetical examples of these conditions:

Condition

Type of
Security

Yield at
Auction

Interest
Coupon
Rate

Discount
(price below
par)

10-year Note
Issue Date
8/15/2005

4.35%

4.25%

99.196069

Below par price

required to equate
to 4.35% yield

Premium
(price above
par)

10-year Note
reopening*
Issue Date:
9/15/2005

3.99%

4.25%

102.106357

Above par price

required to equate
to 3.99% yield

Price

Explanation

http://www.treasurydirect.gov/RI/OFNtebnd
* In a reopening, we sell an additional amount of a previously issued security. The reopened security has
the same maturity date and interest rate as the original security. However, as compared to the original
security, the reopened security has a different issue date and usually a different purchase price.
Source: (http://www.treasurydirect.gov/indiv/research/indepth/tnotes/res_tnote_rates.htm)

Let us unpick the examples given by the US Treasury. The US Treasury sells
its Treasury Notes by auction, and the strength of demand in that auction
determines the price at which the $100 Treasury Notes are sold. The price
people are willing to pay, as revealed in their auction bids, reflects the yield
to maturity they wish to receive it is the yield to maturity at which they
will be happy to invest their money in this Treasury Note instead of other

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assets (such as bank deposits). Because of the inverse relationship, if they

wish to receive a high yield to maturity they will bid a low price.
Look at the first row in the table. It illustrates the case where the US Treasury sets a coupon interest rate of 4.25 per cent per annum on a new issue of
ten year Treasury Notes but, because investors seek a higher yield, they bid
at a price below $100 for each bond. The outcome of the auction is that the
$100 Treasury Notes are sold at only $99.196069. At that market price the
yield to maturity (or, yield) is 4.35% pa instead of 4.25% pa.

 Review Question
What would the situation be if investors were happy to receive a yield to maturity below
the coupon interest rate (perhaps because bank deposits and similar alternative
investments are paying lower yields)?
The example shown in the second row of the table illustrates that situation.

6.3.3 Fluctuations in price and yield

The example used by the US Treasury to illustrate the inverse relationship
between a bonds price and its yield focuses on one moment in time the
price determined by demand and supply at the auction run by the US
Treasury to sell its 10-year Treasury Note at the time it is issued. And we,
similarly, focused upon the issue price in our simple example of a one-year
bond.
But it is important to understand that the price of such a US Treasury Note
fluctuates throughout its life. The bond is traded on bond markets throughout each trading day; since the markets for it are New York, London, and
Tokyo, which are in different time zones, effectively the 10-year US Treasury
Note is traded around the clock. Purchases and sales are made on electronic
platforms by banks and finance houses acting as primary dealers and by
inter-dealer brokers.
The original buyer, having bought at the US Treasury auction, can sell the
bond, and others buy or sell according to their calculations of the profit (and
risk) that the transactions will produce for their portfolios. Investors and
dealers can also borrow and lend 10-year Treasury Notes in repo (repurchase) deals, and can trade in derivatives swaps, options, and forward
contracts whose value is based on US Treasury Notes. But here we focus
on spot or cash purchases and sales of the 10-year Treasury Note and their
near continuous effect on movements in its price and, in the opposite direction, its yield.
The balance of demand and supply causes the bonds market price to rise
and fall each day and, indeed, throughout the trading day. Each fall in the
market price of the bond implies a rise in the yield to maturity. Each rise in
the bonds market price implies a fall in the yield to maturity. Active market
trading of 10-year US Treasury Notes does, in fact, cause the bonds price to
fluctuate and therefore continually causes changes in its yield to maturity.
Figure 6.1 illustrates the changes in the 10-year Treasury Note yield over
three and a half hours of trading on Christmas Eve 2009 in the United States.
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Figure 6.1 Changes in Treasury Note Yield over 31/2 hours, 24 December 2009
Yield to maturity
%

3.81
3.80
3.79
3.78
3.77
3.76
3.75
3.74

10.00am

11.00am

12.00pm

1.00pm

2.00pm

3.00pm

4.00pm

Source: Finance/Yahoo.com

 Review Question
Please look carefully at Figure 6.1. What does it tell you?
Here are some of the things we can read from Figure 6.1.
The vertical axis on the left measures the yield to maturity of the 10-year US
Treasury Note (as a yield per annum). The horizontal axis measures time
from 9.30am to 1.00pm in New York (Eastern Standard Time) on 24 December 2009. Therefore a point on the blue line shows the yield at a point of time
on that morning.
The figure shows that the yield recorded one minute after the market
opened at 9.30 am was 3.764% pa, and transactions by market dealers had
caused it to rise to 3.807 % pa by 1.00 pm.
Although the yield had risen overall by the end of the morning, both rises
and falls had been witnessed minute-by-minute during the morning.
What does the chart tell us about the price of the 10-year Treasury Note?
The answer follows from the principle that the yield on a bond is inversely
related to its price. The yields increase between the start and end of the
morning implies that the market price the price agreed in deals between
buyers and sellers fell during the morning.
Another way to look at the phenomenon is that, if the yield had stayed at its
starting level of 3.764% pa, that yield and its corresponding price would
have led traders to attempt to sell a greater volume of these bonds during
the morning than the volume others wished to buy at that yield and price.
The pressure of that excess supply pushed the price down during the
morning and hence pushed the yield up (ultimately to 3.807 % pa), generating balance between demand and supply.

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There are many factors that influence demand and supply of a bond from
minute-to-minute, hour-to-hour, or day-to-day, and it is difficult to identify
the cause of any one movement in yields and prices especially if we are not
directly engaged in trading and the market community. But major changes
identifiable by looking at yield movements over a longer time scale can
sometimes be more easily related to external events. Let us try to understand
some of the big bond market events of recent years.
Figure 6.2 shows the same data as previously the yield on the 10-year
Treasury Note but now over a longer time period. Here the yield over the
two years prior to 24 December 2009 is shown. It shows some substantial
changes in yield. From June 2008, when the yield was 4.245% pa, it fell to
2.096 % pa in December 2008, and then rose again to 3.936% pa by June 2009.
Figure 6.2 Treasury Note Yield for Two Years Prior to 24 December 2009
%
4.4
4.0
3.6
3.2
2.8
2.4
2.0| | | | | | | | | | | | | | | | | | | | | | | |
2008M01

2008M07

2009M01

2009M07
Source: Finance/Yahoo.com

 Review Question
Why did that large dip in yields occur?
It is helpful to remember that the fall in the yield between June and December 2008 corresponds to a rise in price. The largest fall in yields and price
rise in those months occurred from October 2008. In those months the price
was driven up by investors switching their investments away from other
assets and into 10-year Treasury Notes and other government bonds. The
switch occurred because of uncertainty about the risk of other assets, such as
the deposits and bonds issued by banks, following the shock of the bankruptcy of the Wall Street bank, Lehman.

6.3.4 Value of time

In Section 6.3 we examined the nature of a return on a financial security by
focusing on a government bond and studying the principle stated at the
beginning:

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Unit 6 Introduction to Finance Returns, Time and Risk

There is an inverse relationship between the return on a security and the securitys
market price.
We have used the example of a ten year US Treasury Note, but the same
general principles apply to other bonds with fixed coupon rates. Later (in
Section 6.6) we discuss whether the inverse relation between a securitys
return and its price also applies to other financial securities such as equities
shares or common stock issued by a company.
But, first, we want to examine in more detail, and more formally, the relation
between the price of a bond, its yield, and time. In Section 6.2 we introduced
the idea that returns are related to time and risk. We will examine risk in
Unit 7. In this Unit we concentrate on the idea that the yield on a government bond is a measure of the value of time not risk. In order to do that,
in Section 6.5 we introduce the concepts of:
Discount Rate
Present Value
Internal Rate of Return.
The concept of compound interest is the foundation for understanding the
discount rate, present value, and internal rate of return, so Section 6.4
introduces the concept of compound interest for you to study.

6.4 Compound Interest

Let us begin with a warning: This Section and Section 6.5 use simple algebra.
That means that we use symbols to represent concepts, categories and
numbers; for example, we use B to represent the coupon amount invested in
a bond instead of using the numerical amount $100, which we used before.
It also means that we use simple algebraic operations such as the square of a
value, or its cube, or, more generally, its exponential. If you are not currently
familiar with algebra there is no reason to worry, because, when we use it,
we explain the logic of the analysis and its basis in reality.
Using algebra makes the concepts and the calculations more simple, but,
first we will use the more cumbersome or awkward method of manipulating
a numerical example to illustrate the idea of compound interest.

6.4.1 A numerical example of compound interest

Let us use a similar example to the one we used in Section 6.3.1, but with
one difference. The new element is that we now assume that the bond has a
maturity of three years instead of one year.
How much interest is received over three years by the person who buys the
bond, whose par value is $100, at issue? And what is the total final value of
the $100 investment at the end of the three years? To answer those questions
we need to know what happens to the interest coupon received at the end of
each year:
Simple interest is received if the bondholder receives the coupon at the
end of each year and exchanges it for cash.

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Compound interest is received if the bondholder receives the coupon at

the end of each year and re-invests it at the same rate of interest (in this
case, the same coupon rate) until the bond matures in three years.
The coupon rate, which is the interest rate received because the bondholder
buys the bond at par value ($100), is 10% pa. Therefore, if the bondholder
chooses simple interest, he or she will receive the following payments:
Interest received at end of year 1:

Interest received at end of year 2:

Interest received at end of year 3:

Redemption value received at end of year 3:

$100

Final (total) value of the investment:

$130

In the case of simple interest the investor receives $30 in interest over three
years and the final value of the investment reaches $130. How much interest
is received and what is the final value in the case of compound interest?
The key difference is that the investor invests each years interest coupon;
therefore, he or she receives interest on the interest in addition to interest on
the original capital invested. As a result, the investor receives higher
amounts of interest at the end of each year, for each years total includes
interest on previous years reinvested interest. In Table 6.1 the total received
each year is shown in Row 4, and its components are shown in Rows 13. As
shown in the final column, the total interest received on the bond during its
three-year life is $33.1 and the total final value of the investment, including
the capital invested, is $133.1
Table 6.1

Coupon Rate over 3 Years

Row
1

Coupon received on
capital invested

Coupon on the
coupon received at
end of Year 1 and
reinvested
Coupon on the
coupon received at
end of Year 2 and
reinvested
TOTAL coupon
received each year

18

TOTAL over
3 years

End of year 1

End of year 2

End of year 3

10 (= 100
0.1)

10 (= 100
0.1)

10 (= 100
0.1)

30.1

1 (= 10
0.1)

1 (= 10
0.1)

2.1

1.1 (= 11
0.1)

1.1

12.1

33.1

10

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Unit 6 Introduction to Finance Returns, Time and Risk

Because compound interest enables investors to receive interest upon

interest, it leads to greater final value of wealth than simple interest, or, in
other words, a faster rate of growth of wealth.
The magic of compound interest
The ability of compound interest to increase wealth at a faster rate than simple interest
can be shown more powerfully than our example of a three year bond with an annual
coupon allows.
More frequent interest payments increase the growth rate of wealth. If we consider a
bond with an annual coupon of the same amount which is paid and reinvested in two sixmonthly instalments (a coupon rate of 5% every six months, instead of 10% pa), total
interest payments over the three years would be higher. (Why?) We could also consider
compounding interest payments daily, or, in simple mathematical models, continuous
compounding of interest.
And if we consider any investment (even one paying a coupon rate of 10% at the end of
each year) over several decades instead of three years, the final value will be very much
higher than under simple interest. Here is an example from a personal finance website
FinancialWeb (http://www.finweb.com/investing/compound-interest.html):
One of the secrets of the wealthy is long-term investments that pay compounded interest.
Every savvy investor, when given a choice between a good investment with compound interest
and a great investment with simple interest, will pick the good investment every time. They
know that, over time, the investment that compounds will outperform the other.
Heres an example. Lets say you have three friends; Charlie, Kim, and Sally. Each one has
money to invest. Charlie has $30,000. Kim and Sally each have $10,000 to invest. Charlie
places his money into a 30-year investment which pays 12% simple interest annually. Kim and
Sally also put their money into 30-year investment vehicles at 12% annual interest. However,
theirs is compound interest, with Kims compounding yearly and Sallys investment
compounding quarterly.
After 30 years, heres what their accounts would look like:
The total value of Charlies investment has grown to $138,000 (principal
and interest).
The total value of Kims investment is $299,599.22.
The total value of Sallys account has become $347,109.87.
Moreover, if Sally made $50 additional deposits every two weeks during the
30-year period, her balance would increase to $755,859.58!
As you can readily see, even though Charlie had three times as much money to invest initially,
the compounding investments of Kim and Sally greatly outperformed his investment in the
long run.

Whether you rely on the web or a physical meeting with an investment adviser or
financial salesperson you might be given any one of many similar examples of compound
interest. Often prefaced with the banner The magic of compound interest you might
even be told that compound interest is the eighth wonder of the world or that Einstein
described it as the most powerful force in the universe (he did not).

6.4.2 A formula for compound interest

Examining numerical examples as we have in Section 6.4.1 is time consuming and does not make it easy to see the essential features that are common
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to all examples of compound interest. Using an algebraic formula overcomes

those weaknesses and simplifies both our understanding and our calculations.
Another advantage of using an algebraic formula to isolate the essentials of
compound interest is this. Recall that in this Unit we are not interested in
compound interest only for its own sake; we are examining it as a step on
the road to understanding the concept of a bonds yield to maturity as a
measure of returns. Using the algebraic formula for compound interest
enables us to simplify the analysis of yield to maturity, because that formula
is related to the formula and concept of the discount factor, and, as you will
see in Section 4.3.1 the discount factor is key to understanding yield to
maturity.
Here is the basic formula for compound interest on a bond:

FV = B(1 + i)n
What does it say?
FV is the symbol we use here for Final Value. (In the numerical example
we used in Section 6.4.1 the Final Value of the investment was $133.1)
B stands for the initial investment in the bond. (In the numerical
example we used in Section 6.4.1 the amount invested in the bond
was $100)
i
is the interest rate received. (In the numerical example we used in
Section 6.4.1 the interest rate was the coupon rate, 10% pa. We can
express that as i = 0.1)
n is the number of periods over which we are compounding interest.
(In the numerical example we used in Section 6.4.1 interest was
compounded each year and in our example there were three years so
n = 3)
By writing n as an exponential index, (1 + i)n, we are saying that the sum of
the terms inside the parentheses is multiplied by itself n times. Another way
of expressing that multiplication is (1+i) raised to the power n. (In the
numerical example we used in Section 6.4.1 that is (1 + 0.1)3 or (1.1)3 which
equals 1.331)
So, the formula tells us that the Final Value of a $100 investment in a bond, if
the coupon is paid once a year and reinvested at the same interest rate, is
$100 multiplied by one plus the annual rate of interest (expressed as a
decimal) raised to the power of n which is the number of years it is invested.
Why? What is the reasoning behind this formula? We can see the logic by
considering the position at the end of each year for a three-year bond with
compound interest:
At the end of year 1, the value of the investment plus interest received is:
B + iB, which can be written as:

B(1+i)1
At the end of year 2, that amount, B(1+i), has been invested for the twelve
months of year 2 and gained interest which increases its value to

B(1+i)(1+i) = B(1+i)2

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At the end of year 3, that amount, B(1+i)(1+i), has been invested for the
twelve months of year 3 and gained interest which increases its value to

B(1+i)(1+i) (1+i) = B(1+i)3

In other words, if we denote that amount at the end of year 3 as the investments final value, FV, and remember that in our compound interest
formula n stands for the number of years (3 here), FV = B(1+i)3 = B(1+i)n.

6.4.3 Present value and the internal rate of return

The concept of compound interest, as explained in Section 6.4.2, enables us
to calculate the future value of a sum invested at present. It involves thinking forward from now into the future. Now we explore an equivalent
property of compound interest: it enables us to calculate the present value of
a sum receivable (or payable) in the future. It involves thinking backward
from a point in the future to the present.
The concept of present value underlies many techniques and measurements
in finance so it is important to understand it thoroughly before starting
specialised finance courses. In this section we explain present value and we
use it to define a bonds yield to maturity.
You have already read the general idea behind present value in Section 6.2.
The example we gave there was that because of impatience an individual
might consider an amount of $100 today as equal to the promise of $105 to
be received with certainty one year later. In that example, the present
value, now, of $105 one year from now is $100. Implicit in it is the idea that
$105 two years from now would be less desirable and would, therefore, have
a present value below $100. More generally, the present value of any future
amount of money is lower, the further in the future it is.

Present value of a single future receipt of money

We can apply that general idea to any future sum of money. We can also
calculate the present values of a series of future amounts of money and add
them to obtain a total present value of a stream of future income or payments.

 Review Question
Please pause to give some thought to the question of how we can use that idea
calculating the present values of a series of future amounts of money and add them to
obtain a total present value of a stream of future income or payments to calculate the
value of a bond.
We will explain the answer later in this section.
However, to calculate present value we need to go beyond the general idea
of present value and make the technique precise using algebra. We can start
by using the formula that we used for calculating the final value the
amount after n periods - of an investment in a bond with compound interest:

FV = B(1 + i)n

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Remember that in that example, B is the amount invested now. Therefore it

is the sum now that is equivalent to the amount FV in the future.
We can rearrange the compound interest equation to highlight B and to
show its value explicitly. That rearrangement gives us this formula:

1 
FV 
=B
 (1+ i) n 
That formula tells us that the present value now, B, of a future sum FV
received after n periods is FV divided by (1 + i)n.
It also tells us that B is smaller than FV. How so? Since i and n are positive,
(1 + i)n is positive and greater than one. Therefore to obtain B we are dividing FV by a number greater than one; such division yields a number smaller
than FV.

 Review Question
How did we carry out that rearrangement?
If you remember anything from previous encounters with algebra, you recall
that any equation remains unchanged if we carry out the same operation on
each side.
The rearrangement is achieved by dividing both sides of the compound
interest formula

1 

FV = B(1 + i)n by (1 + i)n , which gives us FV 
n  = B.
 (1+ i) 

 Review Question
Let us think about that formula for the present value of a future sum of money. Although
it is a formula which we have derived by using simple algebra, its validity depends on the
reasoning behind the algebra rather than mathematical rules alone.
The logic behind the present value formula is that if an individual has the
sum of B now they could invest it at the rate of interest i, compound, and
have FV after n periods. Therefore the amount B now is valued as equal to
the amount FV after n periods; it is the present value of FV. Since a smaller
amount now is treated as equivalent to a larger amount in the future, there
is a preference for a given sum now over an equal sum later; but why?
Because receiving a sum of money after a delay involves an opportunity cost
of time, the opportunity cost is the interest that could have been gained if
the money were received now and invested at compound interest.
Because the present value of a future sum of money is smaller than the
future sum, the process of calculating present value is known as discounting. In accounting and corporate finance, the present value of future net
revenue is known as discounted cash flow. The amount of the reduction is

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Unit 6 Introduction to Finance Returns, Time and Risk

determined by the discount factor. In the present value formula, the

discount factor is:

(1+ i) n
Take a good look at that formula for the discount factor. It represents a
number that we use to multiply FV. Since that number is smaller than one (it
is one divided by a number which is larger than one) the multiplication
produces a present value lower than FV. The size of the discount factor
depends on two things:
i, the interest rate
n, the number of periods over which the future sum is to be
discounted.
The higher is i, the smaller is the discount factor; in other words, a higher
interest rate implies a higher preference for money at present in a comparison between the desirability of receiving $100 in the future and $100 now.
Within the formula for the discount factor, i is referred to as the discount
rate. You will examine the discount rate in more detail in Section 6.5.

Present value of a stream of future receipts

The same principles for calculating the present value of a single future
receipt apply to calculating the present value of a stream of future receipts,
(sums of money to be received in successive future periods). The technique
for calculating the present value of a future stream of income is important
for determining the value of a bond, because a bond is a promise of a stream
of future payments. It can also be used for determining the value of other
financial securities that offer a stream of future payments, but we concentrate on bonds here. Let us see how to calculate the present value of such a
stream.
We can explore the technique using the example of a bond illustrated in
Table 6.1. Look again at Row 4, which shows the coupons received at the
end of each year for three years. What is the present value of each years
payment?
Using the present value formula we can calculate each as follows:



 (1 + i ) 

Present value of coupon received at end of year 1: $10 

Present value of coupon received at end of year 2: $11

 (1 + i)2 



 (1 + i ) 

Present value of coupon received at end of year 3: $12.1

The present value of that bonds stream of coupon receipts is the sum of
those three present values:

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1 

1 
 + $11 (1 + i)2  + $12.1
3
 (1 + i ) 
 (1 + i ) 

Total PV of coupon receipts: $10 

At first sight, that total present value of coupon receipts might seem to be
the value you would put on the bond now, or, in other words, the price you
would be willing to pay for the bond now. You might argue that the reason
people buy bonds is to receive the coupon interest payments, therefore the
value of the bond now is the present value of those interest payments. But
that would be wrong. The formula in the previous paragraph does not tell
us what the value of the bond is.

 Review Question
Please pause to consider this question: why does that formula not give us the value of
the bond now?
There are two reasons, or omissions that we need to correct, before reaching
the right formula for the value of the bond now.
The first is that the stream of coupon interest payments is not the complete
stream of cash receipts the bondholder expects to receive in the future. In
addition to those interest payments, the bond promises to pay the investor
the redemption value when the bond matures. If, as we have assumed
previously, the investor buys the bond now for $100 at its par value, he or
she expects to receive $100 redemption when the bond matures at the end of
three years.
To take that redemption amount into account we should calculate its present
value and add it to the total present value of the bonds stream of payments.
The present value of $100 at the end of three years is

1 
$100 
3
 (1 + i ) 
and if we add it to the present value of the stream of coupon payments we
have: Total PV of future receipts from the bond investment, which is

1 

1 

1 

1 
$10 
 + $11 (1 + i)2  + $12.1
3  + $100 
3
 (1 + i ) 
 (1 + i ) 
 (1 + i ) 
The second omission we need to correct before calculating the value of the
bond now is that we need to think carefully about which interest rate to use
as the discount rate, i.
That probably seems like a puzzling issue. So far, we have managed well by
assuming that we can use the coupon interest rate in our examples of
compound interest and present value, but there are other ways to choose the
discount rate. And one alternative is crucial for determining the bonds yield
to maturity, which is the measure of return that is the main focus of this
unit. In the next section, 6.5, we consider the choice of discount rate more
fully.

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6.5 Discounting and the Yield to Maturity

In Section 6.4 you studied compound interest, the discount factor, and
present value on the basis of a simple assumption about the interest rate and
discount rate. The examples and principles you studied were based on the
assumption that an investor receives a yield equal to the coupon yield. We
assumed that the individual buys the bond at the price B or $100 which is its
par value. Because the price is at par value, the coupon interest rate (10% pa
in the numerical example of Table 6.1) is a simple annual yield on the
investment. Compound interest is achieved by re-investing each coupon
amount at the same coupon rate. Consequently, we have been able to use the
coupon rate as the discount rate, i, in calculating the present value of the
stream of future payments expected by the investor.
But matters are more complicated if the investor buys the bond at a price
different from par value. The bond might be bought at issue (for example,
the US Treasury auction) for a market-determined price different from par
value, or it might be bought in the secondary market at a price different
from par value. In either case the current yield on the bond that the investor
expects is different from the coupon interest rate. Remember from Section
6.3.1 that if, for example, the price at the time of purchase is below par value,
the purchaser receives a current yield higher than the coupon interest rate. If
we represent the price paid per bond as P, and the coupon amount as C, the
current yield is (C/P)
100 per cent pa, while the coupon interest rate, with
B representing the bonds par value, is (C/B)
100 per cent pa.
There might be an argument for using the current yield instead of the
coupon interest rate as i in the present value formula to calculate the present
value of the stream of future receipts on a bond. However, the current yield
is not a full measure of the returns on a bond. Why not? If the bond was
bought at a price below its par value, the bondholder will receive returns in
two components.
The first is the coupon amounts (measured by the current yield).
The second is the capital gain received at maturity when the bond is
redeemed at its par value, above its purchase price, and that gain has
to be added to the sum of coupon payments. If the bond were
purchased at a price above its par value that second element would be
a capital loss, which reduces total returns below the sum of the coupon
payments.
A measure of yield that does take all elements of the bonds returns into
account is the yield to maturity. To understand the meaning of the yield to
maturity let us look again at the present value of a bonds future stream of
payments, using the numbers in our previous example:

1 

1 

1 

1 
PV = $10 
 + $11 (1 + i)2  + $12.1
3  + $100 
3
 (1 + i ) 
 (1 + i ) 
 (1 + i ) 
From that formula you can see that there are two quantities that are predetermined givens, the coupon amounts ($10, $11, $12.1) and the
redemption payment at maturity ($100). The present value, PV, is not a

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predetermined given. If we specify the discount rate, i, we can calculate the

present value, but it is important to note that the present value, PV, will
differ according to the value that we use for the discount rate.
To calculate the yield to maturity we conduct a different exercise by assuming that PV is, in fact, predetermined. If there are three predetermined
values the coupon amounts, the redemption payment, and PV there is no
scope for considering the effect on PV of varying the discount rate. In this
exercise the task is reversed; using the given values of the three predetermined quantities we can calculate the value of the discount rate, i, that is
consistent with them. That value of i is the yield to maturity.
What is the reason for assuming that PV is predetermined? It is not just an
arbitrary assumption that we make to demonstrate a new concept. Instead, it
is based on a reasonable view about markets and investors decisions. The
underlying logic is this:
We reasonably assume that the price at which an investor chooses to buy and hold
the bond equals the present value to him or her of the bonds future coupon payments and redemption payment.
In the real world we know the bonds price, because it is the actual price
agreed in actual transactions at auction or on the secondary bond market.
Since we know the price and can reasonably assume that the price equals the
present value to the investor of the bonds future payments, we can treat the
bonds PV as predetermined (equal to the known price) and, with the
coupon amounts, the redemption payment and PV predetermined we can
calculate i as the yield to maturity.
We have reached the definition and explanation of a bonds yield to maturity. To summarise the rather dense argument so far:
The yield to maturity of a bond is the value of i that reduces the present value of the
bonds future payments to a PV equal to the price of the bond.
Now that you have studied the meaning of a bonds yield to maturity you
are in a position to give a technical answer to two questions that we posed at
the beginning of this unit.

 Review Question
The first question was why is a bonds yield inversely related to its price?
How would you answer that, now?
Our answer is this. The measure of a bonds yield is its yield to maturity. A
bond promises a fixed stream of coupon payments and redemption payment, therefore the higher is the discount rate the lower is the present value
of that stream; while a lower discount rate implies a higher present value.
We can assume that the bonds present value to an investor equals its price,
and we define the discount rate consistent with a particular price as the
bonds yield to maturity when its price is at that level. Therefore a low price
implies a high discount rate, or, in other words, a high yield to maturity; a
high price implies that the bonds yield to maturity is low. Graphically, the

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changes over time in the yield on 10-year Treasury Notes, which are illustrated in Figure 6.2 or similar charts, are an inverse reflection of the
changes that occur in its price hourly, daily, weekly or over other periods.

 Review Question
The second question was what is the connection between the return on a bond and the
value (or price) of time?
How would you answer that now?
Our answer is this. The yield to maturity is a measure of the bonds return.
That yield is defined as the discount rate that, when applied to the bonds
future stream of payments, discounts the stream to a present value equal to
the current price. In the case of a US Treasury Bond, that discounting reflects
the preference for present rather than future payments and the yield to
maturity is, therefore, a measure of the value that is placed upon time the
price of time.

 Review Question
Is the yield to maturity on every bond a measure of the value of time?
Please pause briefly to consider that.
For a US Treasury Bond the yield to maturity is a measure of the value (or
price) of time because it is assumed that such securities are riskless. In the
case of bonds issued by other borrowers we seldom make the same assumption. Consequently, for them, the yield to maturity contains two elements
the value, or price, of time, and the price of risk (compensation for time, and
compensation for bearing risk). If we compare the yield to maturity of a 10year US Treasury Note and that on a 10-year bond issued by a US corporation, the latter is usually higher than the US Treasury Bonds yield. It is
higher by an amount the spread or risk premium that measures the extra
compensation investors require to compensate them for the risk attached to
the corporate bond. In Unit 7 you will study the meaning and implications
of risk relating to bonds and other financial assets.

6.6 Returns on Equities

All financial assets are expected to offer returns to those who invest in them.
Those returns might be negative in any particular period, but financial assets
are held because in the long run they are expected to generate positive
returns. So far, we have focused on only one type of financial asset riskless
government bonds. Finance, however, generates thousands of different
types of financial assets, ranging from simple bank deposits to complex
financial derivatives, and each offers returns of a particular type. Clearly, we
need to consider more than the return on riskless government bonds. In this
section we turn attention to a financial asset that is a major source of finance

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for corporations in developed, market economies equities, shares, or

common stock.
Apart from bank loans, bonds and equities are the two great categories of
investment securities though which large corporations obtain finance in
advanced financial systems. The return on a corporate bond is subject to the
same principles as a government bond, with the additional feature of a risk
premium. But the nature of the return on a companys equity is fundamentally different in principle, and so are the ways in which we measure that
return.

6.6.1 Equities share in corporations residual income

The return on a bond is based upon a contractual obligation upon the issuer
to pay a coupon rate of interest. The example we have used assumes the
coupon interest rate is fixed, as it usually is, while the market-determined
yield to maturity varies. There are types of bond that are exceptions. Some
might pay a coupon interest rate that varies; and some might have a zero
coupon, so that the investors return comes wholly from the capital gain
generated by issuing the bond at a discount below par value (redemption
value). But the typical bond has a fixed positive coupon interest rate. The
issuer is legally obliged to pay the coupon at the specified dates and failure
to do so is usually designated as a default with negative consequences for
the issuer.
By contrast, the owner of an equity in a corporation has no legal right to a
regular payment. They expect a return, but do not have a legal right to a
specified return. What is the nature of the return that an equity owner
expects?
The return on an equity the income that any stock market investor expects
has two basic components:
One is a dividend that the corporation decides to pay; each year the
corporations board decides how much of its current profit to pay to
equity owners as a dividend.
The second is the capital gain the investor expects to obtain from
increases in the market price of the share.
The two elements, dividend and capital gain, are connected in several ways.
To understand their relationship we begin by examining how both the
dividend and capital gains have their source in profits from the firms
operations its earnings. To analyse the links between dividends and capital
gains, we introduce the concept of earnings in Section 6.6.2.

6.6.2 Earnings
Over a period one fiscal year, for example the corporation makes profits
from its operations. Those profits can be measured in several ways. For
calculating returns on equity the usual quantity is a measure of net income
called earnings. Earnings are calculated as operating profits (operating
income net of operating costs) minus interest, taxes, depreciation, and
amortisation. Shareholders are the legal owners of the company and earn-

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ings are the sum that is available for distributing to shareholders from the
companys operations.
Earnings and the legal status of finance
Please note that earnings are calculated net of interest, because interest on bonds and
also on other sources of credit has to be paid and is treated as a cost by shareholders.
Bondholders and other creditors have a legal claim on the companys income that is
higher than the shareholders legal claim. Bondholders have senior claims, of varying
degrees of seniority, whereas shareholders legal claim is a claim on residual income and,
hence, the most junior. This means that shareholders only have a legal claim on the
income or assets of the company after bondholders claims and other senior claims (such
as claims due to the tax authorities) have been paid.
The company may split its earnings into two main uses, dividends and
retained earnings:
it may distribute earnings to shareholders as a dividend, and
it may retain earnings in the company, which means expanding the
companys assets (its cash holdings, or new plant and machinery, or
the acquisition of another company, or other assets).
Both dividends and retained earnings are valuable to equity owners. Dividends are a cash payment to the individual shareholder. Retained earnings
are not assigned directly to shareholders, but they increase the net worth of
the company and therefore the underlying value of each shareholding.
Because each share is an ownership stake a claim upon the residual value
of the company an increase in the companys net worth is a benefit to the
shareholders. The increase in net worth that results from retained earnings
might generate a capital gain for the shareholder.
Please note the word might. Whether retained earnings do generate a
capital gain depends upon whether the increased net worth is reflected in an
increase of the share price during the relevant period. The share price of a
company listed on a stock market reflects investors expectations about the
future, and is subject to many forces that cause prices to fluctuate. Consequently, there are at least two reasons why retained earnings that increase a
companys net worth might not show as a rise in share price.
One is that various other forces (such as increased pessimism about
general economic conditions) might offset any effect of retained
earnings on the share price.
The second is that the retention of earnings by the company might be
regarded as a bad omen for the companys future health.
In 2004 a shareholder in General Motors might have taken the view that
retaining earnings to accumulate assets in an automobile industry which
does not have good prospects is less desirable than distributing earnings in
dividends to shareholders, who could then reinvest them in a dynamic new
company like Google. So General Motors making large retained earnings
might have cast doubt on whether the company had the ability to make
decisions that would benefit shareholders.

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As you can see, retained earnings do not have a direct correlation with a
companys share price, and increases in retained earnings do not translate
directly into capital gains. However, retained earnings do represent an
increase in net worth of the company, and this increase in net worth represents an increase in the fundamental value of a shareholders stake.
Therefore an important measure of the benefits that shareholders obtain is
the sum of retained earnings and dividends, or, in other words, earnings.
It would be useful if we could measure the shareholders benefits as a yield,
giving a number that an investor, who is choosing between shares and
bonds, can compare to yields to maturity on bonds. Unfortunately, that is
not an easy task. To consider the difficulty, let us look at some commonly
accepted measures of shareholders benefits.
Since earnings are a measure of the benefits accruing to shareholders from
the companys operations, one measure is earnings per share, EPS, calculated
simply as the ratio of total earnings to the total number of shares that have
been issued by the company.
For shareholders to calculate the yield from shares, the earnings per share
need to be compared to the price of the share. Therefore a standard measure
of earnings yield is the earnings/price ratio or its inverse. Its inverse, the
price/earnings ratio (or P/E ratio) is widely used in investors daily conversation as a way of comparing the prices of different companies shares.
An investor might weigh a shares earnings/price ratio against a bonds
yield to maturity, but it is not an equivalent measure.

 Review Question
Please pause briefly to consider why a shares earnings/price ratio is not equivalent to a
bonds yield to maturity as a measure of returns. What are the differences?
We can identify the following five main differences:
1 The earnings/price ratio expresses the companys earnings as a
percentage of the amount invested in an equity (its price). Although
earnings are the basis for dividends, and retained earnings contribute
to the net assets owned by shareholders, earnings in a period are not
the same as what the shareholder receives. The yield on a bond
measures the payments received by the investor (bondholder) as a
percentage of the amount invested (bond price).
2 The earnings/price ratio measures one years earnings against the
current price of the companys shares, unlike a bonds yield to
maturity, which is based on a multi-period stream of payments. In that
respect, the earnings/price ratio is more similar to, but certainly not
the same as, a bonds current yield (the coupon payment in one year as
a percentage of the bonds current price).
3 The earnings/price ratio is backward looking, because it expresses as a
percentage of the current share price the companys earnings over the
previous fiscal year. Described more fully as the historic
earnings/price ratio or its inverse the historic P/E ratio, its time
perspective differs from that of a bonds yield to maturity, which
relates future payments to the bonds price. We could use a forwardlooking version of the earnings/price ratio, by using a forecast of the

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current or next years earnings. But that forward-looking measure

highlights another difference between the earnings/price ratio and
yield to maturity, which is number 4 on our list.
4 The future earnings of a company are not predictable with a high
degree of certainty. Predictions of earnings over the next twelve
months may be made with a measurable degree of confidence but no
certainty, and beyond twelve months uncertainty is too great. If we
switch attention from earnings to dividend payments, shareholders
cannot make certain predictions, both because earnings cannot be
forecast into the distant future and because the shareholder does not
have a legal right to a fixed or certain dividend from those earnings.
The future payments on a bond, however, are as certain as legal
obligations can be, and can be calculated (making allowance for the
probability of default, a probability calculated by methods such as
those of ratings agencies).
5 A related difference is that a share is legally seen as part of the
companys capital for the entire life of the company (and it has that
status unless and until the company changes its issued share capital,
perhaps by buying shares back). And we assume that companies are
intended to continue forever. In other words, the legal features of a
share do not include a predetermined redemption or maturity date,
and calculating the return, whether as earnings or dividends, takes no
account of an expected redemption of the invested capital. Clearly,
that is different from the principles underlying a bonds yield to
maturity.

6.6.3 Total return on equities

The list in Section 6.6.2 shows why the earnings/price ratio is not comparable to a bonds yield to maturity. But another measure, total shareholder
return, enables us to overcome two of the factors that make the measures so
different.
Total shareholder return in a single period (let us say one year and assume
the company pays a dividend once each year) is the change in the share
price capital gain if its positive plus dividend per share received in that
period, expressed as a percentage of the share price at the start of the period.
(In addition to normal dividends, shareholders might have received special
payments and those, too, may be included, but we can ignore them here.)
That measure focuses directly upon the two elements of income received by
the shareholder instead of the companys earnings it overcomes problem
number 1 in our list.
We can write that definition of total shareholder return (TSR) as a formula.
Let P0 be the share price at the start of the period, let P1 be the share price at
the end of the period, and let D be the dividend per share received during
the period. Then the return, expressed as a percentage is:

 P
P0 + D 
TSR =  1
  100
P0

By this point it is likely that you have a query about the issue that we
examined fully when studying bond yield, the fundamental idea that, as
stated at the start of Section 6.3:

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There is an inverse relationship between the return on a security and the securitys
market price.
You have studied that inverse relationship in depth for bond yields. Does it
apply to the return on equity and share prices, too? The formula for total
shareholder return makes clear that it does. Think about the price at a point
of time P0. The formula shows that for any given level of the future price P1
and of the dividend, D, the TSR will be high when P0 is low and low when
P0 is high. That is because of two factors: a low starting price means that the
capital gain over a period is high (or capital loss is low); and a low starting
price means that any given total of capital gain and dividend is a higher
percentage of the starting price.
Using the companys TSR we can also overcome the problem shown as
number 5 in our list: the absence of a maturity date. That is because we can
measure the TSR over a number of years with a defined start and finish date.
To achieve that we use the formula for the one-year TSR to measure each
years TSR and assume that dividends are reinvested in the equity instead of
being cashed and withdrawn. However, that long term measure does not
give equivalence to a bonds yield to maturity because it is still a backward
looking measure, and because the calculation does not include a final
redemption of capital like a bond holder expects to receive on the maturity
date.
The main use of such historic measures of TSR is for comparing the performance of shares in one company against those of another. Companies
themselves present their TSR in the annual reports and on their websites.
Figure 6.3 shows one chart that BT, a fixed-line telecoms company listed on
the London Stock Exchange, enables us to calculate on its website:
Figure 6.3 Total shareholder return, BT Group plc TSR shows the return on investment
a shareholder receives over a specifid time frame. It is shown as a percentage change
and includes both the change in share price and dividents received.
% change

30
20
10
0
-10
-20
-30
-40
|

Jan-2009

Mar-2009

May-2009

Jul-2009

Sep-2009

Nov-2009

Source BTPLC.com

In Unit 7 we will look at research which uses the total shareholder return to
compare historic returns on shares with the historic returns on bonds; it
attempts to throw light on a phenomenon known as the equity premium:

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have the returns on equities and bonds performed in the way we would
expect if investors regard equities as more risky than bonds?

6.7 Crunching the Numbers

In this unit you have been studying the returns on bonds and equities. What
will happen when you are confronted, in your office, by the need to calculate the return on an investment? Will you turn to what you have
remembered from this Unit, insert the numbers for your investment, and
carefully do the math (or, using the English idiom traditional in London
rather than New York, carefully do the maths)? We hope not.
That does not mean that we want you to forget what you have learned in
this unit. We want you to understand fully the concepts and reasoning you
have studied here, but doing the math is separate from understanding the
concepts and there are tools that make it easy to crunch the numbers. The
tools are based on those principles but are designed for quick calculation.
They are readily available on the web, and in common applications like
Microsoft Excel.
In this section we introduce you to two tools that we can use for calculating
a bonds yield to maturity; first tools that are on the web, and secondly how
to use Microsoft Excel.

6.7.1 Calculating yield to maturity: using web based calculators

Many websites provide you with free access to financial calculators that are
well designed for calculating the yield to maturity of bonds, and other
financial measures. One useful, but very simple one is on the moneychimp.com website:
http://www.moneychimp.com/calculator/bond_yield_calculator.htm.

Exercise
At this point please visit that page. You will see an interactive calculator that looks like
this:

Please insert the numbers from the example of a US bond, a 10-year Treasury Note,
studied in Section 6.3.2. Try inserting the price, par value, coupon rate, and years to
maturity, of the bond which the US Treasury website says was sold below par value at
auction. Then click Calculate.

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 What answer do you get for yield to maturity? Is it the same as shown on the US
Treasury website illustrated in Section 6.3.2?
Consider the three year bond studied in section 6.4.1. You know the par value, the
coupon rate and the years to maturity. Enter these into the calculator, and then calculate
the yield to maturity using three different values for the Current Price (i) a current price
above par value; (ii) a current price equal to par value; and (iii) a current price less than
par value. How do you explain the yields to maturity that you calculate?

6.7.2 Calculating yield to maturity, using Microsoft Excel

If you are familiar with Microsoft Excel, or Apple iWork Numbers, or
Gnumeric or similar applications, you already know that such spreadsheet
applications are powerful tools. They enable you to carry out complex
calculations using functions, including functions that calculate compound
interest, present values, and the yield to maturity of a bond.
Now we would like you to study the following, optional, exercise if you are
an experienced user of Microsoft Excel.
For this exercise, we would like you to watch a tutorial in a screencast by
David Harper on how to calculate a bonds yield to maturity using Excel. It
is on the bionic turtle website at:
http://www.bionicturtle.com/learn/article/yield_to_maturity_9_minute_s
creencast/
and you can also visit the same screencast on YouTube at:
  


The main purpose of the exercise is to enable you to learn how to use Excel
for calculating yield.
A second objective is to introduce you to the principles (and the practice in
Excel) of dealing with a bond that pays its coupon at shorter intervals than
annually. In the example used by David Harper, the coupon is paid semiannually, so that the bondholder receives a coupon every six months and
reinvests it.

Exercise
After you have studied David Harpers screencast, please use the bond examples you
used in moneychimp in Section 6.7.1, and insert the numbers into an Excel formula, but
with one change from Section 6.7.1. Instead of assuming that coupons are paid annually,
assume that the same annual coupon is paid in two semi-annual instalments. Then check
to see whether the yield to maturity results for the 10-year Treasury Note and for the
imaginary three-year bond are higher with semi-annual coupon payments than they were
with annual payments.
 If so, please explain the result.

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6.8 Conclusion
In this unit you have studied the returns on a bond, focusing on measuring
return as the yield to maturity. We have used the yield to maturity to
explore two fundamental ideas in finance:
the existence of an inverse relation between the yield on a bond and
the bond price, and
the concept of yield (return) as the price of time
Yield is the price of time if a bond is riskless. We assume that US Treasury
Bonds can be treated as riskless. If a bond is not riskless, its yield includes an
extra element, a risk premium.
We also examined the measurement of the return on an equity. Equities are
not riskless, so their yield does include a risk premium.
We have reached the point where, in order to study returns further, we must
examine risk fully. In Unit 7 you study the basics of how risk is analysed in
finance.

References and Websites

Bianco, M, T Jappelli and M Pagano (2002) Courts and Banks: Effects of
Judicial Enforcement on Credit Markets, Centre for Economic Policy
Research: Discussion Paper 3347, April.
Bionic Turtle:
http://www.bionicturtle.com/learn/article/yield_to_maturity_9_minut
e_screencast/
Financial Web, The Magic of Compound Interest:
http://www.finweb.com/investing/compound-interest.html
Harper, David (2008) Yield to maturity 9 minute screencast:
http://www.bionicturtle.com/learn/article/yield_to_maturity_9_minut
e_screencast/ and http://www.youtube.com/watch?v=NV0S8pKvje8
London Stock Exchange:
http://www.btplc.com/Sharesandperformance/Sharepricegraphs/TSRg
raph/index.cfm
Moneychimp, Bond yield calculator:
moneychimp.com/calculator/bond_yield_calculator.htm
US Treasury, Treasury Notes: Rates & Terms, TreasuryDirect:
http://www.treasurydirect.gov/indiv/research/indepth/tnotes/res_tno
te_rates.htm
Yahoo.com: (http://finance.yahoo.com/echarts?s=%5ETNX
YouTube screencast:   


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