*What exactly is yield and how does it differ from coupon rate?*
The term yield is used to
describe the return on your investment as a percentage of your original
investment.

**Yield in the case of stocks**

Yield is the ratio of
annual dividends divided by the share price. If a stock can be expected to pay
out Rs 1 as dividend over the next year and is currently trading at Rs 50, its
dividend yield is 2%. Or, if the stock price drops to Rs 25, its dividend yield
rises to 4%.

The yield can be
calculated based on dividends paid over the past year or dividend expectations
for the next.

**Yield in the case of bonds**

In the case of a bond,
the yield refers to the annual return on an investment. The yield on a bond is
based on both the purchase price of the bond and the interest promised – also
known as the coupon payment.

Although a bond’s coupon
rate is usually fixed, its price fluctuates continuously in response to changes
in interest rates in the economy, demand for the instrument, time to maturity,
and credit quality of that particular bond.

As a result, after bonds
are issued, they trade at premiums or discounts to their face values until they
mature and return to full face value.

Let’s say a bond’s face
value is Rs 1,000 on which an investor can earn 5%. This means that the coupon
is 5% and an investor who buys the bond and holds it till maturity will get Rs
50 every year over the tenure of the bond.

Now the price of the bond
drops in the market to Rs 980. That means the current yield is Rs 50 divided by
Rs 980 = 5.10%.

Later, the price of the
bond rises to Rs 1,030. That means the current yield is Rs 50 divided by Rs
1,030 = 4.85%.

As the price of the bond
fell, its yield increased.

Because yield is a
function of price, changes in price result in bond yields moving in the
opposite direction. There are two ways of looking at bond yields - current
yield and yield to maturity.

**Current Yield**

This is the annual return earned on the price paid for
a bond. It is calculated by dividing the bond's coupon rate by its purchase
price.

For example, let’s say a
bond has a coupon rate of 6% on a face value of Rs 1,000. The interest earned
would be Rs 60 in a year. That would produce a current yield of 6% (Rs 60/Rs
1,000).

When a bond is purchased
at face value, the current yield is the same as the coupon rate. But let’s say
the bond was purchased at a discount to face value – Rs 900. The current yield
would be 6.6% (Rs 60/ Rs 900).

**Yield to Maturity**

This reflects the total
return an investor receives by holding the bond until it matures. A bond’s
yield to maturity, or YTM, reflects all of the interest payments from the time
of purchase until maturity, including interest earned on interest.

The formula for
calculating YTM is as follows.

Let's work it out with an
example: Par value (face value) = Rs 1,000 / Current market price = Rs 920 /
Coupon rate = 10%, which means an annual coupon of Rs 100 / Time to maturity =
10 years.

Taking the above example
and using the formula, the YTM would be calculated as follows:

YTM = Rs 100 + [(Rs
1,000-Rs 920)/10] / (Rs 1,000+Rs 920)/2

After solving the above
equation, the YTM would be 11.25%.

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