A bond’s yield to maturity (YTM) is the percentage return that it is expected to generate...
A bond’s yield to maturity (YTM) is the percentage return that it is expected to generate if the bond is assumed to be held until it matures. Calculating a bond’s YTM requires you to make several assumptions. Which of the following is one of these assumptions?
The bond is callable.
The probability of default is zero.
Homework Answers
The assumption made behind the calculation of YTM is that probability of default is zero.
Why?
Because the calculation of YTM considers the payment of complete coupon payments and the redemption value. If there were any default in the payment of any coupon payment or the redemption value, it will not correctly reflect the Yield to Maturity. For example, if there is a bond trading @ $940 paying 8% coupon payments for 5 years and it will redeem at par value. Let's say the bond will redeem at $1000. Now, YTM can be easily calculated since we have all the required variables.
We don't assume that the bond is callable since YTM is the percentage return that it is expected to generate if the bond is assumed to be held until it matures. In case the bond is callable, it means it will be redeemed early. This means that bond is not held until maturity if it is called.
Hence, we assume that the probability of default is zero.
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