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Author: BenHacker Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35363  
Subject: Re: Basic question on bond interest Date: 9/4/2011 12:26 AM
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Joel,

I said:
Money next year is worth more than money in 5 years, and that is why the YTM (which use an implied time value of money) is >5%.

You said:
In this case I believe you are incorrect. The YTM calculation does not take time-value into account. To account for time-value, you would have to discount the income stream.

Then you said:
I believe the YTM formula favors the first option in this case because it would assume you could re-invest your money at the coupon rate.

I think we may be mincing words here, but this is the definition of YTM as I believe is commonly taught in finance / CFA coursework:

---- YTM is the discount rate that when applied to all future cash flows, produces a present value equal to the purchase price of the security. This is another way of saying that the YTM is the rate that makes the NPV zero.

There is no "reinvestment" assumption built into a YTM calculation, although many folks conceptually look at the "discount rate" (aka, time valuation of money) as being rationally equivalent to a reinvestment assumption.

There is much confusion on this subject, and even several papers written attempting to clarify the difference between end result of an investment (terminal wealth / future value) and what the IRR or YTM style return calculation actually is saying.

One example -- http://www.economics-finance.org/jefe/econ/ForbesHatemPaulpa...

I would be interested in my two examples (ignoring call problems, etc) if you truly think the only reason #1 is preferable is because of "reinvestment" assumptions? I don't think it is. You get money sooner in option #1... period. that is more valuable in all scenarios (where reinvestment is >0%). HOW MUCH more valuable, is a debatable point and may or may not be captured properly by YTM calculations, but it's more valuable... no question IMO.

Ben
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