The Accuracy of Approximations of Yield to Maturity
FINANCIAL PRACTICE AND EDUCATION, Fall/Winter 1995
Posted: 28 Jun 1998
Although the implicit yield of cash flows, such as the internal rate of return (IRR) and the yield to maturity (YTM), are crucial concepts in valuation, many finance students do not have an intuitive grasp of these concepts. This is because the complexity of the computations and difficulty of solving repetitive examples make it hard to visualize the functional forms involved. Approximation methods not only furnish short-cut computational means, they also provide excellent teaching tools for showing the intuition behind the complex concepts. This article investigates the accuracy of four existing methods that have been suggested to estimate YTM and shows how the size and sign of the approximation errors vary with bond parameters. The quadratic formula is more accurate than the other methods and performs best for 12%, 15-year bonds priced over $850. Bond price appears to have a dominating effect on the approximation error of all models.
JEL Classification: C60
Suggested Citation: Suggested Citation