Arbitrage-Free Valuation Models

Regarding YTM, which of the reasons given for the expected return is *most likely* incorrect?

Incorrect. A steep yield curve is one reason why YTM is not a good measure for the expected return on a bond because the reinvestment of coupons will have a different rate than the bond’s YTM.

Correct! For YTM to be a valid measure of a bond’s expected return, interest rates must be stable. In this case, Barend indicates that stable interest rates are a reason why YTM is not a good measure of expected return; however, that is incorrect. Interest rate volatility is a valid reason why YTM is a poor expected rate of return measure.

Incorrect. A significant risk of default is one reason why YTM is not a good measure of a bond’s expected return.

Steep yield curve

Interest rate stability

Significant risk of default