Analysing and Interpreting the Yield Curve, 2nd Edition

APPENDIXBond Yield Measurement

In the Preface to this book, we noted the importance of the yield curve to an understanding of the bond markets. But before we discuss the yield curve, we must be familiar with the concept of bond yields and bond yield measurement. So in this Appendix we introduce the subject for beginners.

From an elementary understanding of financial arithmetic we know how to calculate the price of a bond using an appropriate discount rate known as the bond's yield. This is the same as calculating a net present value of the bond's cash flows at the selected discount rate. We can reverse this procedure to find the yield of a bond where the price is known, which is equivalent to calculating the bond's internal rate of return (IRR) to a specified maturity date. There is no equation for this calculation and a solution is obtained using numerical iteration. The IRR calculation is taken to be a bond's yield to maturity or redemption yield and is one of various yield measures used in the markets to estimate the return generated from holding a bond. We will consider these various measures as they apply to plain vanilla bonds.

In most markets, bonds are generally traded on the basis of their prices but because of the complicated patterns of cash flows that different bonds can have, they are generally compared in terms of their yields. This means that a market‐maker will usually quote a two‐way price at which he will buy or sell a particular bond, but it is the yield