6.

Failure to reinvest coupons will result in a realized yield that's well below a bond's YTM. In fact, the only way to actually generate a rate of return that's equal to the bond's promised yield at time of purchase is to reinvest all coupons at a rate of return that equals the bond's YTM!

This is the reinvestment assumption that's part of any present value-based measure of yield, and is the basis of reinvestment risk. This is a key point in the Level 1 exam, so make sure to remember it!

The bond will be held to maturity.

All coupon payments are received in a prompt and timely fashion.

Limitations:

Due in part to computational procedures, as well as the embedded assumptions noted above, there are at least two major shortcomings in the YTM measures that you should be aware of:

These yield measures assume that all cash flows can be discounted at the same rate.

These yield measures assume that all coupon payments will be received in a prompt and timely fashion, and reinvested to maturity, at a rate of return that's equal to the appropriate solving rate.

d: Explain the importance of reinvestment income in generating the yield computed at the time of purchase.

The reinvestment assumption that's embedded in any present value-based yield measure implies that all coupon (or principal) payments must be reinvested at a specific rate of return; for example, the bond's yield to maturity. That means is a bond has a YTM of 8%, the only way you'll actually earn 8% on the investment is to reinvest all the coupons (and any other intermediate cash flows) at an 8% rate of return. Anything more or less, and the actualy yield will be more or less. Thus, YTM is only an estimate of what you might earn given you fulfill the reinvestment assumption! All three sources of return (coupons, principal, and reinvestment income) have to be considered in what Fabozzi calls total dollar return.

f: Discuss the factors that affect reinvestment risks.

The key point to take away from this is that you need to reinvest coupon cash flows at the YTM or your realized return will not be equal to the YTM. This is called reinvestment risk. YTM (and other traditional yield measures) contain a good deal of reinvestment risk. Other things being equal, the amount of reinvestment risk embedded in a bond will increase with:

Higher coupons - because there's more to reinvest.

Longer maturities - because the reinvestment period is longer.

g: Compute the bond equivalent yield of an annual-pay bond and compute the annual-pay yield of a semiannual-pay bond.

Failure to reinvest coupons will result in a realized yield that's well below a bond's YTM. In fact, the only way to actually generate a rate of return that's equal to the bond's promised yield at time of purchase is to reinvest all coupons at a rate of return that equals the bond's YTM!

This is the reinvestment assumption that's part of any present value-based measure of yield, and is the basis of reinvestment risk. This is a key point in the Level 1 exam, so make sure to remember it!

The bond will be held to maturity.

All coupon payments are received in a prompt and timely fashion.

Limitations:

Due in part to computational procedures, as well as the embedded assumptions noted above, there are at least two major shortcomings in the YTM measures that you should be aware of:

These yield measures assume that all cash flows can be discounted at the same rate.

These yield measures assume that all coupon payments will be received in a prompt and timely fashion, and reinvested to maturity, at a rate of return that's equal to the appropriate solving rate.

d: Explain the importance of reinvestment income in generating the yield computed at the time of purchase.

The reinvestment assumption that's embedded in any present value-based yield measure implies that all coupon (or principal) payments must be reinvested at a specific rate of return; for example, the bond's yield to maturity. That means is a bond has a YTM of 8%, the only way you'll actually earn 8% on the investment is to reinvest all the coupons (and any other intermediate cash flows) at an 8% rate of return. Anything more or less, and the actualy yield will be more or less. Thus, YTM is only an estimate of what you might earn given you fulfill the reinvestment assumption! All three sources of return (coupons, principal, and reinvestment income) have to be considered in what Fabozzi calls total dollar return.

f: Discuss the factors that affect reinvestment risks.

The key point to take away from this is that you need to reinvest coupon cash flows at the YTM or your realized return will not be equal to the YTM. This is called reinvestment risk. YTM (and other traditional yield measures) contain a good deal of reinvestment risk. Other things being equal, the amount of reinvestment risk embedded in a bond will increase with:

Higher coupons - because there's more to reinvest.

Longer maturities - because the reinvestment period is longer.

g: Compute the bond equivalent yield of an annual-pay bond and compute the annual-pay yield of a semiannual-pay bond.