Yield to maturity (YTM) is a measure of the total return you can expect to receive from a bond if you hold it until it matures. It takes into account the bond's current market price, its face value (the amount you'll get back when it matures), the coupon payments you'll receive along the way, and the time remaining until maturity.
Let's say you have a bond that you bought for $1,000, and it will mature in 5 years. Each year, it pays you $50 as interest (we'll call this the coupon payment). At the end of the 5 years, you'll get back your initial investment of $1,000.
To calculate the yield to maturity, you would need to consider the total amount you'll receive over the 5 years compared to what you initially paid. Let's do the math:
You'll receive $50 every year for 5 years, which totals $250 in coupon payments. At the end of the 5 years, you'll also get back your initial investment of $1,000.
So, the total amount you'll receive is $1,000 (initial investment) + $250 (coupon payments) = $1,250.
Now, we need to compare this $1,250 to what you initially paid for the bond, which was $1,000.
The yield to maturity would be the annual rate of return that makes the present value of all these cash flows equal to the bond's price ($1,000). Let's imagine, for easy math, that this comes out to be 5%.
In simple terms, yield to maturity is like knowing how much money you'll make each year if you buy a special type of IOU (bond) and keep it until it's time to get your money back. It's like if you loaned $1,000 to someone who pays you $50 every year for 5 years and then gives you back your $1,000 at the end. The yield to maturity tells you how much interest you're getting on that loan each year, which is about 5% in this example.
