Financial Markets For The Rest Of Us|
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
means a 20% yield, the same as the interest rate. Now suppose that right after you open the account with the initial $1,000 deposit you become in need of money but now you cannot withdraw your investment as it is locked in for a year. If the account allows you to transfer ownership, you may be able to find buyers who are willing to buy out your position at a discount. A motivated seller will always attract bargain hunters. Since you need the money real bad you quickly transfer the ownership of your account to the highest bidder who is offering $800. At the end of the year the new account owner collects the $200 in interest payment on the account. Let's plug in our yield formula for the new owner.
Yield = 200 / 800 = 0.25 or 25%
As you can see our bargain hunter was able to realize a much better gain than the 20% interest on the account.
Treasury bond or other debt instrument yields work just about the same way, whereby the interest payments of a (marketable) bond remain constant while the price of the bond itself may change depending on the market demand, therefore affecting the yield. As a side note to our example, at the end of the one year term the bargain hunter would also collect the entire $1,000 (on top of the $200 interest payment) of which $200 is pure profit that may or may not have to be returned to the original account owner depending on the agreement between the buyer and the seller. In terms of treasuries however, the final owner gets to collect the principal at maturity, and the collective yield realized on the investment is known as yield to maturity. So in our example, the bargain hunter's yield to maturity would be:
Yield to maturity = 400 / 800 = 0.50 or 50%.
Not bad, huh? …
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