Yield to Maturity-YTM

YTM means Yield to Maturity.  Academically YTM is defined as the market interest rate that equates a bond's present value of interest payments and principal repayment with its price. 

To understand it better, YTM can be defined as the compound rate of return that investors will receive for a bond with a maturity greater than one year if they hold the bond to maturity and reinvest all cash flows at the same rate of interest. It takes into account purchase price, redemption value, coupon yield, and the time between interest payment.

YTM's Relation With Price ? YTM and the price of the Bonds have inverse relations i.e. if YTM goes up the price of the Bonds will come down and when YTM goes down the price of the Bonds will go up.   The following table gives an indication between the YTM and current yield, when bonds are quoted at discount or at a premium or at par :-   Bond Selling At. Relationship Discount Coupon Rate < Current Yield < YTM Premium Coupon Rate > Current Yield > YTM Par Value Coupon Rate = Current Yield = YTM Thus, the YTM will be greater than the current yield when the bond is selling at a discount and will be less if it is selling at a premium.  HOW YTM IS RELEVANT  FOR VALUATION OF INVESTMENTS IN INDIA / What are  FIMMDA Rates?:- Banks in India are required to value their assets at the end of the each quarter at least.   As per RBI's  implementation of prudential norms, banks are required to mark-to-market (M2M)  their investments in government securities and other Non SLR investments in Held for Trading (HFT) and Available for Sale (AFS).   This means that if interest rates rise during a year, the market value of the bonds will fall and in case interest rates  go down, the market value of the Bonds will rise. For the sake of uniformity in valuation, RBI has asked Banks to use the prices / YTMs released by FIMMDA every month for valuation of their securities.    While banks have to make a provision when the value of their bonds depreciate, they cannot book profits.    However, they are allowed to write back the depreciation provided in the previous year.  DEFICIENCIES IN THE YTM METHOD? YTM, is a projection of future performance.  Since future interest rates are unknown, YTM must assume a reinvestment rate, and it uses the YTM rate itself.  Thus YTM is an implicit function that can only be evaluated by the method of successive approximations. In practice it is virtually impossible to reinvest the interest payments at exactly the YTM rate.  Usually they are accumulated in an account at a lower interest rate before being reinvested.  This means that the YTM almost always overstates the true return.  If the interest earnings are spent rather than reinvested, the return will be even lower.  It is also important to recognize that the interest payments are normally trimmed by a tax bite, making it impossible to reinvest the full amount of each payment. YTM is almost always quoted in terms of bond-equivalent yield. This reflects the fact that bond interest payments are normally made twice a year at half the coupon rate.  The compounding of the (assumed) reinvested interest payments twice a year results in a slightly higher annualized return than would be the case for once-a-year reinvested interest payments at the full coupon rate.    Thus YTM expressed as bond-equivalent yield slightly understates the YTM when viewed as the annualized compound rate of return. In the absence of taxes, YTM would be an accurate measure of return if the yield curve were flat and interest rates remained constant over the life of the bond.  It becomes a poorer measure as the yield curve steepens, or as the purchase price deviates further from par.   YTM FOR ZERO COUPON BONDS - WHY SUPERIOR METHOD? The reason that YTM applies exactly to a zero coupon bond is that there is no interest to be reinvested.  The entire return comes from the difference between the purchase price and the face value of the bond.  In ordinary bonds, this difference is treated as a capital gain/loss and taxed when sold.  However in a zero coupon bond, that gain is treated as interest income and taxed annually according to the gain in accreted value. Since there are no interest payments to reinvest and therefore none to spend, achieving the quoted YTM is automatic when a zero coupon bond is held to maturity.  Of course this ignores the annual income tax bite.