This chapter explores the basis of bond pricing and portfolio management.

This chapter is
organized into the following sections:
1.

Yield Concepts

2.

Bond Market Instruments

3.

Principles of Bond Price Movements

4.

Duration

5.

Term Structure of Interest Rates

6.

Bond Portfolio Immunization

Pure Discount Bond (Zero Coupon Bond)

A pure discount bond promises to pay a certain amount at a specified time in the future (par
value). The instrument is sold for less than this promised future payment.
There is no payment between the original issue of the bond and the maturity of the bond. The
investors return is the difference between the amount that he/she paid for the bond and the
promised future value (yield).
The general bond pricing formula for all bonds can be stated as:

Where:
Pi
Ct
Bond Discount

= the price of the bond I

= cash flow from the bond I at time m

The bond discount

is =thethedifference
between
par value
theI selling price.
ri
annualized
yield tothematurity
on and
bond
Yield to Maturity
t
= the time in years until the bond matures
The yield is the promised payment that the bond holder will realize after buying and holding
the bond until maturity.
The appropriate current price of a bond is determined by calculating the present value of the
par value.
In order to calculate the present value of the par value, we must first know the appropriate
interest rate.

The interest rate is dependent upon general interest rate levels in the economy, and the
riskiness of the bond. That is, the probability that the investor receives the par value as
promised.
Suppose you have a pure discount bond that agrees to pay $1,000 five years from today. The
bond discount rate is 12%.
What is the appropriate price for this bond?
0

??

P i=

C
(1 + r

$1,000

m
i

PURE DISCOUNT BOND

Bond Discount = Face Value Current Price
Bond Discount = $1,000-$567.43
Bond Discount = $432.57
0

-$567.43
Price

$1,000
Par Value

COUPON BONDS
Coupon bonds are longer term bonds making regularly scheduled payments between the
original date of issue and the maturity date.
Suppose you have a bond with a $1,000 face value that matures 1 year from today. The
coupon rate is 12% and the bond makes semi-annual coupon payments of $60. The bond
yield is 13%.
0

??

$60

$1,000
$60

Par Value =

$1,000

Yield

13% annual (13/2 =6.5% semiannual)

Coupon =

12% with semiannual payment of $60

M
60
$1,060
Ct
=
P= $
+
= 56.34 + 934.56 = $990.90 Pi
t
2
1.065 1.065
t = 1 (1 + r i )

year

Maturity = 1