MFIN 503 – Fixed Income

Lecture 3
Government Bond Market
Outline
 Government Bonds
 Zero bonds
 Treasury bonds
 TIPS

 Dirty and Clean Prices

 Informational Content on Yield Curve

Government Bond Market
1. Zero Coupon Bonds
Separate Trading of Registered Interest and Principal of Securities (STRIPS)

A zero-coupon bond is a bond that pays no coupon. The only relevant cash
flows is the face value on the maturity date.

Why an investor should be interested in bond hat pays no interests?

 All bonds earns interest! Even zero bonds
 A 30-yr zero face value $1000 is selling for $53.54 (assume 10% p.a.
semi-annual compounded)
 If you invest $53.54 today, the money will grow to $1,000 in 30 years.
1. Zero Yield Curve
1. Zero Yield Curve and Pricing
In terms of pricing, the zero can be priced as follows:

𝐹𝑉
𝑃= 𝑛𝑇
𝑟
1+𝑛

where FV is the bond face vale and T (years) is the bond Maturity.
Following same example, a 20-yr zero bond price is $142.05:

𝐹𝑉 1000
𝑃= 𝑟 𝑇𝑛
= 10% 2𝑥20
= $142.05
1+𝑛 1+ 2
1. Discount factors
In terms of pricing, the zero can be also used to obtain discount factors.
For a bond paying FV $1, the associated discount factor can be obtained
as:
Maturity Yield DF
0.5 3.00% 0.99
1.0 3.30% 0.97
1.5 3.45% 0.95
2.0 3.60% 0.93
2.5 4.20% 0.90
3.0 4.50% 0.88
3.5 4.60% 0.85
4.0 4.80% 0.83
4.5 4.80% 0.81
5.0 5.00% 0.78
2. Treasury bond market
Treasury Notes (T-notes)
 Bond with semi-annual coupons
 Matures between 2 and 10 years
 Semi-annual coupons

Treasury Bonds (T-bonds)

 Bond with semi-annual coupons
 Matures between 20 and 30 years.
 Semi-annual coupons
Valuation of Coupon Bonds
Coupon Bonds
 Intermediate payments in addition to final principal payment
 Coupon bonds can trade at discounts or premiums to face value
 Valuation is straightforward application of NPV (how?)
Example:
3-year bond of $1,000 par value with 5% annual coupon
Valuation of Coupon Bonds
All coupon bonds are portfolios of pure discount bonds
Valuation of discount bonds implies valuation of coupon bonds

Example:
3-Year 5% bond

Sum of the following discount bonds:

–50 1-Year STRIPS
–50 2-Year STRIPS
–1050 3-Year STRIPS
Example 1
Suppose a T-note with face value of $100m and semi-annual coupons of
5%. The maturity of the bond is 2 years.
From market data, the discount bond prices (STRIPS) are the following:

Maturiy 0.5 1.0 1.5 2.0

Strip .98 .95 .92 .88

Compute the price of the T-note and the yield to maturity (ytm).
Example 1 (Solution)
We can use directly the STRIPS prices to compute the bond prices
assuming zero credit risk.

𝐶1 𝐶2 𝐶3 𝐶4 + 𝐹𝑉
𝑃𝑡 = 1+ 2+ 3+
𝑟 𝑟 𝑟 𝑟4 4
1+ 1 1+ 2 1+ 3 1+
2
2 2 2

1 1 1 1
𝑃𝑡 = 𝑟 1 𝐶1 + 𝑟 2 𝐶2 + 𝑟 3 𝐶3 + 𝑟4 4
(𝐶4 + 𝐹𝑉)
1+ 21 1+ 22 1+ 23 1+ 2

𝑃𝑡 = 𝑍𝑡,1 𝐶1 + 𝑍𝑡,2 𝐶2 + 𝑍𝑡,3 𝐶3 + 𝑍𝑡4 (𝐶4 + FV)

Example 1 (Solution)
𝑃𝑡 = 𝑍𝑡,1 𝐶1 + 𝑍𝑡,2 𝐶2 + 𝑍𝑡,3 𝐶3 + 𝑍𝑡4 (𝐶4 + FV)

𝑃𝑡 = .98 × 2.5 + .95 × 2.5 + .92 × 2.5 + .88 × 2.5 + .88 × 100

𝑃𝑡 = 97.325

The yield-to-maturity (ytm) is computed by:

𝐶1 𝐶2 𝐶3 𝐶4 + 𝐹𝑉
𝑃𝑡 = 1+ 2+ 3+ 4
𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚
1+ 1+ 1+ 1+
2 2 2 2
Example 1 (Solution)
𝐶1 𝐶2 𝐶3 𝐶4 + 𝐹𝑉
𝑃𝑡 = 1+ 2+ 3+ 4
𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚
1+ 1+ 1+ 1+
2 2 2 2

2.5 2.5 2.5 102.5

97.325 = 1+ 2+ 3+ 4
𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚 𝑦𝑡𝑚
1+ 1+ 1+ 1+
2 2 2 2

By using Solver in Excel, we find that ytm = 6.45%

Arbitrage opportunities
Price of 3-Year coupon bond must equal the cost of this portfolio
In General:

If this relation is violated, arbitrage opportunities exist. For example,

suppose that

Short the coupon bond, buy C discount bonds of all maturities up to T

and F discount bonds of maturity T
Example 2
In 2-yr T-note coupon 2%, $1000 FV Maturity Yield DF
is trading at $970.4 Arbitrage opportunities? 0.5 3.00% 0.99
1.0 3.30% 0.97
1.5 3.45% 0.95
Synthetic T-note 2.0 3.60% 0.93
P = .99x10 + .97x10 + .95x10 + .93x1,010 2.5 4.20% 0.90
P = $968.4 3.0 4.50% 0.88
3.5 4.60% 0.85
4.0 4.80% 0.83
Sell T-note and take long position on $10 in 4.5 4.80% 0.81
Strips 1, 2 and 3 yr and $1,010 in Strip 4-yr 5.0 5.00% 0.78
3. Treasury Inflation Protected Bonds
TIPS are bonds that offset the effects of inflation by adjusting the value
of the principal.

The principal value of a TIPS bond is adjusted up and down with the CPI
index.
 Note: Investor’s purchasing power remains intact in cases of deflationary
environment. Adjusted FV never below original FV.

It captures the real interest rate (nominal minus inflation).

 It serves as a market-based benchmark for future inflation!
3. Treasury Inflation Protected Bonds
3. Treasury Inflation Protected Bonds
Cash flows from a regular T-note vs. comparable TIPS bond: both have 2
years to maturity, face value of $1000, and coupon rate = 6% p.a. (semi
annual)
• Assuming the CPI is 10% after the 1st year.
T-note CFs = 30, 30, 30, 1030
TIPS CFs = 30, 30, 33, 1133

• Assuming the CPI is -10% after the 1st year.

T-note CFs = 30, 30, 30, 1030
TIPS CFs = 30, 30, 27, 1027 why?
Treasury Inflation Protected Bonds
Breakeven inflation: captures inflation expectations based on nominal and
TIPS bonds:
BE = nominal – TIPS at same maturity.
Dirty and Clean Prices
Accrued Interest between coupons
The issue arises when you buy/sell a bond between coupon
payment dates.

Unless the bond is purchased on the coupon payment date, the

bond price likely includes the interest that has accrued since then.
 The buyer will miss out one coupon payment (clean price)
 The seller will pocket the accrued interest (dirty price)
Example 3
Assume you acquire a 2-yr T-note with 6% p.a. coupon and $1000
face value.

You hold and sell the bond 3 month later. On the selling date, the
ytm is 5% p.a. semi-annually compounding.

What price would you get for the bond?

Example 3 (solution)
$30 $30 $30 $1,030

6mo 12mo 18mo 24mo

Sell after 3mo

In terms of relevant
cash flows and timing
Example 3 (solution)
1) The (dirty) price of the bond would be:

2) Accrued interest: $15

Half of the coupon in yours already (3mo from first coupon)

3) Clean price = Dirty price – accrued interest = 1031.47 – 15 =

1,016.47
Informational Content on Yield Curve
Term Structure of Interest Rates
The term structure of interest rates gives the relation between the
time to maturity and the yield to maturity of a bond.

Yield curve – graphical representation of the term structure.

 Normal – upward-sloping, long-term yields are higher than short-
term yields
 Inverted – downward-sloping, long-term yields are lower than
short-term yields.
Term Structure of Interest Rates
The U.S. central bank sets the short-term interest rate – the
fed funds rate.
Long term interest rates are the functions of expected short-
term interest rates, in addition there is a risk-premia
associated with uncertainty about the underlying economy
forces, such as the growth rate of the economy, inflation,
etc.
Links to Macroeconomy
 The central bank will respond to macroeconomic forces in
setting the interest rate.
 Thus, the yield curve embeds information about current
and future macroeconomic conditions.
 Conversely, it can serve as a barometer of the economy.
 Inverted yield curves are a leading indicator of recessions.
Example 4: term spread
Expectation hypothesis (EH)
The EH of interest rates states that long-term rates are determined purely
by current and future expected short-term rate.
Similarly, long-term rates can be used to indicate where rates of
short-term bonds will trade in the future.

Long-term rate = Expected path of short-term rate

Limitations: different investors in different parts of the yield curve:

Long-term rate = Expected path of short-term rate + risk premium

Expectation hypothesis (EH)