Advanced Diploma of Financial Planning (ADFP) Practice Test

How is the yield on a bond typically determined?

1. By the issuer's creditworthiness

2. By evaluating yields on similar instruments in the market

3. By the bond's duration

4. By the overall market trend

The correct answer is: By evaluating yields on similar instruments in the market

The yield on a bond is typically determined by evaluating yields on similar instruments in the market. This method takes into account the prevailing interest rates and yields offered by bonds with similar credit ratings, durations, and features, allowing investors to compare potential returns. The market constantly adjusts these yields based on supply and demand dynamics, as well as economic factors. When investors assess a new bond, they look at the yields of existing bonds to ensure that the new bond offers a competitive return relative to similar investments. This establishes a benchmark that reflects what investors might expect in return, enhancing the overall pricing of bonds in the market. While the issuer's creditworthiness does play a role in determining the yield, it is typically factored into the broader context of the prevailing market yields on similar bonds. Additionally, a bond's duration and the overall market trend can influence yields, but they are secondary considerations compared to the comparative assessment of existing market yields. This framework is essential for providing investors with the information they need to make informed decisions about purchasing bonds.