FIXED-INCOME SECURITIES

Chapter 2

Bond Prices and Yields

 Outline

• Bond Pricing
• Time-Value of Money
• Present Value Formula
• Interest Rates
• Frequency
• Continuous Compounding
• Coupon Rate
• Current Yield
• Yield-to-Maturity
• Bank Discount Rate
• Forward Rates
 Bond Pricing

• Bond pricing is a 2 steps process

– Step 1: find the cash-flows the bondholder is entitled to
– Step 2: find the bond price as the discounted value of the cash-flows

• Step 1 - Example
– Government of Canada bond issued in the domestic market pays one-half
of its coupon rate times its principal value every six months up to and
including the maturity date
– Thus, a bond with an 8% coupon and $5,000 face value maturing on
December 1, 2005 will make future coupon payments of 4% of principal
value every 6 months
– That is $200 on each June 1 and December 1 between the purchase date
and the maturity date
 Bond Pricing

• Step 2 is discounting
T
Ft
P0  
t 1 (1  r ) t

• Does it make sense to discount all cash-flows with

same discount rate?
• Notion of the term structure of interest rates – see
next chapter
• Rationale behind discounting: time value of money
 Time-Value of Money

• Would you prefer to receive $1 now or $1 in a year

from now?
• Chances are that you would go for money now
• First, you might have a consumption need sooner
rather than later
– That shouldn’t matter: that’s what fixed-income markets are for
– You may as well borrow today against this future income, and consume
now

• In the presence of money market, the only reason

why one would prefer receiving $1 as opposed to $1
in a year from now is because of time-value of
money
 Present Value Formula

• If you receive $1 today

– Invest it in the money market (say buy a one-year T-Bill)
– Obtain some interest r on it
– Better off as long as r strictly positive: 1+r>1 iif r>0
• How much is worth a piece of paper (contract, bond)
promising $1 in 1 year?
– Since you are not willing to exchange $1 now for $1 in a year from now, it
must be that the present value of $1 in a year from now is less than $1
– Now, how much exactly is worth this $1 received in a year from now?
– Would you be willing to pay 90, 80, 20, 10 cents to acquire this dollar paid
in a year from now?
• Answer is 1/(1+r) : the exact amount of money that
allows you to get $1 in 1 year
• Chicken is the rate, egg is the value
 Interest Rates

• Specifying the rate is not enough

• One should also specify
– Maturity
– Frequency of interest payments
– Date of interest rates payment (beginning or end of periods)
• Basic formula
– After 1 period, capital is C1= C0 (1+ r )
– After n period, capital is Cn = C0(1+ r )n
– Interests : I = Cn - C0
• Example
– Invest $10,000 for 3 years at 6% with annual compounding
– Obtain $11,910 = 10,000 x (1+ .06)3 at the end of the 3 years
– Interests: $1,910
 Frequency

• Watch out for

– Time-basis (rates are usually expressed on an annual basis)
– Compounding frequency
• Examples
– Invest $100 at a 6% two-year annual rate with semi-annual compounding
• 100 x (1+ 3%) after 6 months
• 100 x (1+ 3%)2 after 1 year
• 100 x (1+ 3%)3 after 1.5 year
• 100 x (1+ 3%)4 after 2 years
– Invest $100 at a 6% one-year annual rate with monthly compounding
• 100 x (1+ 6/12%) after 1 month
• 100 x (1+ 6/12%)2 after 2 months
• …. 100 x (1+ 6/12%)12 = $106.1678 after 1 year
• Equivalent to 6.1678% annual rate with annual compounding
 Frequency

• More generally
– Amount x invested at the interest rate r
– Expressed in an annual basis
– Compounded n times per year
– For T years
– Grows to the amount r nT
x(1  )
n
• The effective equivalent annual (i.e., compounded
once a year) rate ra is defined as the solution to
r
x(1  ) nT  x(1  r a )T
n
or n
 r 
r a  1    1
 n
 Continuous Compounding

• What happens if we get continuous compounding

• The amount of money obtained per dollar invested
after T years is
r nT
lim x(1  )  xe rT
n  n
• Very convenient: present value of X is Xe-rT
• One may of course easily obtain the effective
equivalent annual ra
2 3
r r
xe rT  x(1  r a )T  r a  e r  1  r    ...
2 3!
• The equivalent annual rate of a 6% continuously
compounded interest rate is e6% –1 = 6.1837%
 Bond Prices

• Bond price
T
Ft
P
t 1 (1  r ) t
• Shortcut when cash-flows are all identical
T
F F 1 
P  1  T 

t 1 (1  r )
t
r  1  r  
• Coupon bond
T
cN N cN  1  N
P   1  
T 
t 1 (1  r ) t
1  r T
r  1  r   1  r T

– Note that when r=c, P=N (see next example)

 Bond Prices - Example

• Example
– Consider a bond with 5% coupon rate
– 10 year maturity
– $1,000 face value
– All discount rates equal to 6%
• Present value
10
50 1,000 50  1  1,050
P   
 1 
10 
  $926.3991
i 1 (1  6%)
i
1  6%  6%  1  6%   1  6% 
10 10

• We could have guessed that price was below par

– You do not want to pay the full price for a bond paying 5% when interest rates are at
6%
• What happens if rates decrease to 5%?
– Price = $1,000
 Perpetuity

• When the bond has infinite maturity (consol bond)

cN  1  N cN
P 
 1   T
r  1  r T  1  r 
T 
r
• Example
– How much money should you be willing to pay to buy a contract offering
$100 per year for perpetuity?
– Assume the discount rate is 5%
– The answer is
100
P  $2,000
.05
– Perpetuities are issued by the British government (consol bonds)
 Coupon Rate and Current Yield

• Coupon rate is the stated interest rate on a security

– It is referred to as an annual percentage of face value
– It is usually paid twice a year
– It is called the coupon rate because bearer bonds carry coupons for
interest payments
– It is only used to obtain the cash-flows

• Current yield gives you a first idea of the return on a

bond
cN
yc 
P
• Example
– A $1,000 bond has a coupon rate of 7 percent
– If you buy the bond for $900, your actual current yield is
70
yc   7.78%
900
 Yield to Maturity (YTM)

• It is the interest rate that makes the present value of

the bond’s payments equal to its price
• It is the solution to (T is # of semester)
T
Ft
P
t 1 (1  YTM ) t

• YTM is the IRR of cash-flows delivered by bonds

– YTM may easily be computed by trial-and-error
– YTM is a semi-annual rate because coupons usually paid semi-annually
– Each cash-flow is discounted using the same rate
– Implicitly assume that the yield curve is flat at point in time
– It is a complex average of pure discount rates (see below)
 BEY versus EAY

• Bond equivalent yield (BEY): obtained using simple

interest to annualize the semi-annual YTM (street
convention): y = 2  YTM
• One can always turn a bond yield into an effective
annual yield (EAY), i.e., an interest rate expressed
on a yearly basis with annual compounding
• Example
– What is the effective annual yield of a bond with a 5.5% annual YTM
– Answer is
2
 5.5% 
r a  1    1  5.5756%
 2 
 One Last Complication

• What happens if we don’t have integer # of periods?

• Example
– Consider the US T-Bond with coupon 4.625% and maturity date
05/15/2006, quoted price is 101.739641 on 01/07/2002
– What is the YTM and EAY?

• Solution (street convention)

– There are 128 calendar days between 01/07/2002 and the next coupon
date (05/15/2002)
8 4.625%
102.3125
101.739641   128
2
t
 128 8
 YTM  4.353%
t 0 (1  YTM ) 181
(1  YTM ) 181
2 2
– Fed convention: =1+YTM/2*128/181
• EAY is 2
 4.353% 
1    1  4.40%
 2 
Quoted Bond Prices - Screen
 Quoted Bond Prices - Paper
S o u r c e : W a ll S t r e e t J o u r n a l

G o ve r n m e n t B o n d s & N o te s
F r id a y , O c t o b e r 1 6 , 1 9 9 8

R a te M a t u r it y B id Asked C hg Ask
M o /Y r Y ie ld

7 1 /2 Fe b 05n 1 1 6 :3 0 1 1 7 :0 2 -5 4 .3 8

6 1 /2 M ay 05n 1 1 2 :0 2 1 1 2 :0 6 -3 4 .3 5

8 1 /4 M a y 0 0 -0 5 1 0 5 :2 2 1 0 5 :2 4 -1 4 .4 2

12 M ay 05 1 4 2 :1 0 1 4 2 :1 6 -5 4 .4 7

5 1 /2 A ug 28 1 0 8 :1 0 1 0 8 :1 1 -8 4 .9 6
 Quoted Bond Prices

• Bonds are
– Sold in denominations of $1,000 par value
– Quoted as a percentage of par value

• Prices
– Integer number + n/32ths (Treasury bonds) or + n/8ths (corporate bonds)
– Example: 112:06 = 112 6/32 = 112.1875%
– Change -5: closing bid price went down by 5/32%

• Ask yield
– YTM based on ask price (APR basis:1/2 year x 2)
– Not compounded (Bond Equivalent Yield as opposed to Effective
Annual Yield)
 Examples

• Example
– Consider a $1,000 face value 2-year bond with 8% coupon
– Current price is 103:23
– What is the yield to maturity of this bond?
• To answer that question
– First note that 103:23 means 103 + (23/32)%=103.72%
– And obtain the following equation
40 40 40 1,040
1,037.2    
(1  y ) (1  y ) 2 (1  y ) 3 (1  y ) 4
2 2 2 2
– With solution y/2 = 3% or y = 6%
 Accrued Interest

• The quoted price (or market price) of a bond is

usually its clean price, that is its gross price (or dirty
or full price) minus the accrued interest
• Example
– An investor buys on 12/10/01 a given amount of the US Treasury bond with
coupon 3.5% and maturity 11/15/2006
– The current market price is 96.15625
– The accrued interest period is equal to 26 days; this is the number of
calendar days between the settlement date (12/11/2001) and the last
coupon payment date (11/15/2001)
– Hence the accrued interest is equal to the last coupon payment (1.75)
times 26 divided by the number of calendar days between the next coupon
payment date (05/15/2002) and the last coupon payment date (11/15/2001)
– In this case, the accrued interest is equal to $1.75x(26/181) = $0.25138
– The investor will pay 96.40763 = 96.15625 + 0.25138 for this bond
 Bank Discount Rate (T-Bills)

• Bank discount rate is the quoted rate on T-Bills

10,000  P 360
rBD  
10,000 n
– where P is price of T-Bill
– n is # of days until maturity
• Example: 90 days T-Bill, P = $9,800
10,000  9,800 360
rBD    8%
10,000 90
• Can’t compare T-bill directly to bond
– 360 vs 365 days
– Return is figured on par vs. price paid
 Bond Equivalent Yield

• Adjust the bank discounted rate to make it

comparable
10,000  P 365
rBEY  
P n

• Example: same as before

10,000  9,800 365
rBEY    8.28%
9,800 90
• BDR versus BEY
P 360
rBEY    rBD
10,000 365
 Spot Zero-Coupon (or Discount)
Rate
• Spot Zero-Coupon (or Discount) Rate is the
annualized rate on a pure discount bond
1
 B 0, t 
(1  R0,t ) t

– where B(0,t) is the market price at date 0 of a bond paying off $1 at date t
– See Chapter 4 for how to extract implicit spot rates from bond prices

• General pricing formula

T T
Ft
P0     Ft B 0, t 
t 1 (1  R0 ,t )
t
t 1
 Bond Par Yield

• Recall that a par bond is a bond with a coupon

identical to its yield to maturity
• The bond's price is therefore equal to its principal
• Then we define the par yield c(n) so that a n-year
maturity fixed bond paying annually a coupon rate of
c(n) with a $100 face value quotes at par
• Typically, the par yield curve is used to determine the
coupon level of a bond issued at par
1
1
n
100c(n) 100 (1  R ) n

100     c ( n )  0,n

(1  R ) i
(1  R ) n n
1
i 1 0 ,i 0,n
i 1 ( 1  R ) i
0 ,i
 Forward Rates

• One may represent the term structure of interest

rates as set of implicit forward rates
• Consider two choices for a 2-year horizon:
– Choice A: Buy 2-year zero
– Choice B: Buy 1-year zero and rollover for 1 year
• What yield from year 1 to year 2 will make you
indifferent between the two choices?

(1  R0, 2 ) 2
1  F1,1 
(1  R0,1 )
 Forward Rates (continued)

• They are ‘implicit’ in the term structure

• Rates that explain the relationship between spot
rates of different maturity
• Example:
– Suppose the one year spot rate is 4% and the eighteen month spot
rate is 4.5%

(1  R0,18 m ) 3 / 2  (1  R0,1 )(1  F12 m , 6 m )1/ 2

(1.045) 3 / 2  (1.04)(1  F12 m , 6 m )1/ 2 ; F12 m , 6 m  5.51%
 Recap: Taxonomy of Rates

• Coupon Rate
• Current Yield
• Yield to Maturity
• Zero-Coupon Rate
• Bond Par Yield
• Forward Rate