<h3>Study Session 2. Quantitative Methods: Basic Concepts</hw Applications</h3><h3>Subject 5.

Bond equivalent yield</h3>

09/01/2015 21:59

Study Session 2. Quantitative Methods: Basic Concepts

Reading 6. Discounted Cash Flow Applications
Subject 5. Bond equivalent yield
This subject is for LOS 6.f.
Periodic bond yields for both straight and zero-coupon bonds are conventionally computed based on
semiannual periods, as U.S. bonds typically make two coupon payments per year. For example, a zerocoupon bond with a maturity of five years will mature in 10 6-month periods. The periodic yield for that
bond, r solves the equation Price = Maturity value x (1 + r)-10. This yield is an internal rate of return with
semiannual compounding. How do we annualize it?
The convention is to double it and call the result the bond's yield to maturity. The method ignores the
effect of compounding semiannual YTM, and the YTM calculated in this way is called a bondequivalent yield (BEY).
However, yields of a semiannual-pay and an annual-pay bond cannot be compared directly without
conversion. The conversion can be done in one of the two ways:
1. Convert the bond-equivalent yield of a semiannual-pay bond to an annual-pay bond.

2. Convert the equivalent annual yield of an annual-pay bond to a bond-equivalent yield.

Example
A Eurobond pays coupon annually. It has an annual-pay YTM of 8%.
A U.S. corporate bond pays coupon semiannually. It has a bond equivalent YTM of 7.8%.
Which bond is more attractive, all else equal?
Solution 1
Convert the US corporate bond's bond equivalent yield to an annual-pay yield:
Annual-pay yield = [1 + 0.078/2]2 - 1 = 7.95% < 8%.
Therefore, the Eurobond is more attractive since it offers a higher annual-pay yield.
Solution 2
Convert the Eurobond's annual-pay yield to a bond equivalent yield (BEY):
BEY = 2 x [(1 + 0.08)0.5 - 1] = 7.85% > 7.8%.
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<h3>Study Session 2. Quantitative Methods: Basic Concepts</hw Applications</h3><h3>Subject 5. Bond equivalent yield</h3>

09/01/2015 21:59

Therefore, the Eurobond is more attractive since it offers a higher bond equivalent yield.

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