CFA Level I · CFA Level I Exam · Fixed-Income Cash Flows and Types
An investor buys a 3-year annual-pay bond with a 5% coupon and a par value of 1,000 at a price of 1,000, and holds it to maturity. The investor reinvests each coupon at 4%. The realized annual return is most likely:
The realized return is below 5%. Yield to maturity assumes coupons are reinvested at the yield itself. Because coupons are reinvested at only 4%, the terminal wealth is lower than assumed, so the realized annual return is about 4.97%.
- ABelow 5%Correct
- BEqual to 5%
- CAbove 5%
Explanation
Yield to maturity assumes coupons are reinvested at the yield, here 5%. Reinvesting at 4% gives a lower terminal value: 50×1.04²+50×1.04+50+1,000 = 54.08+52+50+1,000 = 1,156.08. The annual return is (1.15608)^(1/3)-1, about 4.97%, below 5%.
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