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Yields: Conventional Yield Measures

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Textbook ELI8 Deeper Dive Cash Flow Yield

Cash Flow Yield: Beyond Regular Payments

Cash Flow Yield is a nuanced measure that extends beyond regular coupon payments, taking into account potential capital gains or losses upon selling the bond. It provides a comprehensive assessment of the annualized rate of return over the entire holding period, considering all cash flows received during the bond's lifetime. Let's break down the mathematics behind Cash Flow Yield with a practical example:

Example Scenario:

Imagine you purchase a bond with the following characteristics:

  • Face Value (F): $1000
  • Annual Coupon Payment (C): $50
  • Purchase Price (P): $950
  • Holding Period: 3 years

Calculation Steps:

1. Annual Cash Flow: Calculate the annual cash flow for each year, considering both coupon payments and the potential gain or loss upon selling the bond.

  • Year 1:

    • Cash Flow = Coupon Payment + (Selling Price - Purchase Price)
    • Cash Flow = $50 + ($1000 - $950) = $100

  • Year 2:

    • Cash Flow = Coupon Payment + (Selling Price - Purchase Price)
    • Cash Flow = $50 + ($1000 - $950) = $100

  • Year 3 (Selling the Bond):

    • Cash Flow = Coupon Payment + (Selling Price - Purchase Price)
    • Cash Flow = $50 + ($1000 - $950) = $100

2. Total Cash Inflows: Sum up the annual cash flows over the holding period.

  • Total Cash Inflows = Cash Flow Year 1 + Cash Flow Year 2 + Cash Flow Year 3
  • Total Cash Inflows = $100 + $100 + $100 = $300

3. Cash Flow Yield Calculation: Calculate the Cash Flow Yield by dividing the total cash inflows by the initial investment (purchase price).

  • Cash Flow Yield = Total Cash Inflows / Purchase Price
  • Cash Flow Yield = $300 / $950 ≈ 0.3158 or 31.58%

Interpretation:

In this example, the Cash Flow Yield of approximately 31.58% reflects the comprehensive annualized rate of return, considering both regular coupon payments and the capital gain or loss upon selling the bond. This measure provides a holistic view of the bond's performance, aiding investors in evaluating the overall attractiveness of the investment beyond conventional coupon payments.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.