Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period of time. Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date. Compound interest is always assumed in TVM problems.
Yield to MaturityNew investors in the stock market should become familiar with the terminology used. Learning key words and phrases will make transactions easier to understand. There are key words and phrases that pertain to stocks and bonds separately. This paper will explain the concept of yield to maturity.
Yield to maturity (YTM) is the rate of return to the investor earned from payments of principal and interest, with interest compounded semi-annually at the stated yield, presuming that the security remains outstanding until the maturity date.
Yield to maturity takes into account the amount of the premium or discount at the time of purchase, if any, and the time value of the investment.
Nearly all bonds are denominated in $1,000 face amounts and the investor pays a percentage of that face. If the investor buys a bond at 80 he or she will pay $800 for every $1,000 bond. If the investor buys a bond at 110 he or she will pay $1,100 for every $1,000 bond.
A bond purchased at a discount to par, or face, value will have a YTM which is higher than the current yield. A bond bought at a premium to par value will have a YTM that is lower than the coupon yield.
Bonds pay interest in arrears; in other words, they pay interest only after it's earned. If our $1,000 bond...