Yield (finance)
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In financial economics, the yield of a financial instrument/security (finance), usually a debt instrument, or other investment is the rate of return the holder earns on that instrument.
The absolute yield levels vary mainly with expectations of inflation. How yields compare between financial instruments tends to depend mainly on the credit worthiness of the lender, and the maturity of the instrument. The least risky instruments, such as government bonds, virtually always yield less than more risky corporate bonds. The relationship between yields and the maturity of instruments of similar credit worthiness, is described by the yield curve. Long dated instruments typically have a higher yield than short dated instruments.
The yield of a debt instrument is generally linked to default probability of the issuer. The more the default risk, the higher the yield would be in most of the cases since issuers need to offer investors some compensation for the risk.
In bond markets, US Treasury bond yields are the benchmark debt instruments because they are backed by the US Government and the risk of default is almost nil. All the other debt instruments' yields are then linked to their default risk.
Inflation is linked to the yield in the sense that fears of high inflation in the future would mean that investors would ask for high yield today.
The yield of a bond is inversely related to its price today: if the price of a bond falls, its yield goes up. Conversely, if interest rates decline (the market yield declines), then the price of the bond should rise (all else being equal).
[edit] Calculating Yield
Yield is often referred to in the bond market. Bonds are frequently traded as a percentage of the par value (the nominal value). For example, a $100 bond payable in one year (with no interim interest payments) may trade for $95. Applying the time value of money formula below, where PV is present value or the current trading value ($95), FV is future value or the redemption value of the bond ($95), r is the yield, and the time period (t) is one year:
PV = FV(1 + r)t
r = PV / FV − 1 = 100 / 95 − 1 = 0.0526 = 5.26%
More detailed calculations are required when there are interim interest payments (coupon payments) and other features.
