YTM question

B

bananass

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so this schweser question is as follows:

if the YTM equals the actual compound return an investor realizes on an investment in a coupon bond purchased at a premium to par, it is least likely that:
a) cash flows will be paid as promised
b) the bond will not be sold at a capital loss
c) cash flows will be reinvested at the YTM rate.
i don't get it can someone explain the reasoning in their answer?
thanks!
 
I’ll give it a go but I’m not too sure myself:
Bond purchased at premium to par, so default is probably not likely, so a) is likely to be true i.e. not the answer.
As for b). Well if they sell it in the future it may well be at a capital loss as bond price approaches par as maturity nears. So unless the markets required yield for the bond decreases bond sale will be at a capital loss.
c) It is a coupon paying bond so reinvestment risk does exist. i see no reason why reinvestment risk is especially high, but i guess it’s unlikely cash flows will be able to be invested at exactly the same rate, as the market will probably move between purchase an interest payments.
I would go for b) over c) but i’m not too sure. Anyone else?
 
Assuming the normal situation: coupons will be paid as promised and we can reinvest them at YTM, the only answer is b) becasue if we sell a bond at a capital gain (at a ptice higher than original purchase price) we will realize a rate of return higher than YTM.
However it is possible that our reinvestment rate was lower than YTM but we were lucky enough to sell our bond to some crazy investor at a premium (or just rates dropped significantly). Consequently in this situation earning the YTM is possible.
However if we are talking about the most probable scenario as is requested, I would choose b).
 
(a) is irrelevant
(b) is highly unlikely because the bond was purchased at a premium
(c) is almost never guaranteed, but possible
Answer: B
 
yea the answer was B.
can someone dumb it down a little for me?
in the question it states the YTM equals coupon rate. How can it be priced at premium then? wouldn’t that make the bond priced at par?
 
i think you got it a little confused. it doesn’t say the YTM equals the coupon rate it says the YTM equals the realized return. So originally the YTM on the bond was lets say 5 %, that means that in order for you to actually realize that YTM you need to receive the coupon payments as promised (at a premium in this case) as well as reinvest those coupons again at the YTM rate of 5%. Any coupons not paid out, or any of the coupons you got and have to reinvest at a lower rate means that you will not realize the YTM on the bond that was promised. In this case, it says that the YTM was realized so it means you did receive all your coupon paymnts and you were able to reinvest at the YTM. All this being true, the only answer that it can be is B.
 
The reason “B” is least likely is because
1. You bought the bond at a premium
2. The actual return is equal to the YTM
Since the bond was bought at a premium and the YTM did not change, the coupon payment was higher than the YTM and as such the bond will decrease in value over time causing the loss on the price of the bond.
Look at it this way:
PV: 103.77
YTM: 6%
Coupon: 10%
time: 1 year
FV: 100
At maturity the bond is worth $100, to get there the bond will decrease in value over the course of the year. Try it on you calculator if it helps
 
Well I think if you look at it like this. If ytd is the same as the coupon then the value of your bond is on par. If you brought it at a premium and on par then for sure your going to incur a capital lose. Also as stated above as the value of the bond will be decreasing because of the coupon(cash flow) that it has already given, so the npv of the cash flow will decrease.
 
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