Which of the following best describes a corporate bond's yield to maturity (YTM)?

• A. The annual interest payment divided by the bond's face value.
• B. The difference between the bond's purchase price and its face value.
• C. The total return an investor can expect to earn if the bond is held until it matures, assuming all coupon and principal payments are made as scheduled.
• D. The current market price of the bond.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of Yield to Maturity (YTM). YTM represents the total return an investor can expect to earn if they hold the bond until its maturity date, assuming all coupon payments and the principal repayment are made as scheduled.
2. Step 2: Differentiate YTM from other bond-related terms. For example, the annual interest payment divided by the bond's face value is the bond's coupon rate, not YTM. Similarly, the difference between the bond's purchase price and its face value is related to the bond's discount or premium, not YTM.
3. Step 3: Recognize that YTM takes into account the bond's current market price, coupon payments, and the time remaining until maturity. It is essentially the internal rate of return (IRR) for the bond, calculated by equating the present value of all future cash flows (coupons and principal repayment) to the bond's current market price.
4. Step 4: Note that YTM assumes reinvestment of all coupon payments at the same rate as the YTM itself, which is a key assumption in its calculation.
5. Step 5: To calculate YTM, use the formula: \( P = \sum_{t=1}^{n} \frac{C}{(1 + YTM)^t} + \frac{F}{(1 + YTM)^n} \), where \( P \) is the current market price of the bond, \( C \) is the annual coupon payment, \( F \) is the face value of the bond, \( n \) is the number of years to maturity, and \( YTM \) is the yield to maturity. Solving for \( YTM \) typically requires iterative methods or financial calculators.