Final answer:
The yield to maturity (YTM) of a bond is the discount rate that equates the present value of all future cash flows from the bond (coupon and principal payments) to its current market price, reflecting both the income and price change as market rates fluctuate.
Step-by-step explanation:
The yield to maturity (YTM) of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. This rate is computed by considering the bond's coupon payments, its face value, the time to maturity, and the current market interest rates. To determine YTM, one would set the present value of all future cash flows from the bond (interest payments plus the principal repayment at maturity) equal to the bond's current market price. This provides an investor with a rate that reflects both the income stream from the coupons and the gain or loss of the bond's value as it approaches maturity.
If the market interest rates increase, investors can find higher yielding investments, making the current bond less attractive unless its price is lowered. Conversely, if market rates decrease, the bond's price may increase as it becomes more attractive relative to the new lower-yielding investments. Hence, the YTM incorporates both the income received and the bond's changing price in response to fluctuating market interest rates, encapsulating the bond's overall return expectation.