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You are on page 1of 38

Introduction and Bond Pricing

1

Teaching staff

• Lecturer in charge

– Dr. Elvira Sojli (Lectures 1‐3, 11)

Associate Professor

– Office hours: Tuesdays 16.00‐17.00 ASB 319

– Email: e.sojli@unsw.edu.au

• Co‐lecturer

– Dr. Shikha Jaiswal (Lectures 4‐10, 12)

– Office hours: Tuesdays 16.00‐17.00 ASB 319

– Email: shikha.jaiswal@unsw.edu.au

• Tutors

– I will put their contact info on Moodle

• Use Moodle discussion forum for course related

questions

Please check Moodle regularly 2

Textbook

• Main textbook: Bodie, Kane and Marcus Investments,

10th edition

• The custom book and the full hardback book are

equivalent

• You may use the 9th edition of the book

• You may or may not get by with an earlier edition of

the book, e.g. the 8th edition

• If you want to do additional exercises, you may want

to buy the solution manual associated with the book

3

Lectures

• For each lecture, the course outline lists

essential readings (which you should really

try to read before the lecture) and

recommended readings (which is good to

read before the lecture)

correspond to the lecture posted on Moodle.

They are meant as a helpful tool, not as a

substitute for the actual lecture

4

Tutorials

• There are weekly tutorials

• Exercises for each tutorial are posted on

Moodle

• You should submit a suggested solution every

week – including week 2!

– You don’t have to get everything right

– You need to actively participate/contribute in

tutorials to get your participation points

– If you miss a tutorial you can attend another one,

inform the relevant tutors

• Only medical certificates will be considered as special

consideration

Participation counts for 11% of the course total,

so it’s important that you participate every week

5

Online Quizzes

• There is an online quiz for every lecture, which

counts 1% each towards your final grade

• Quiz of 5‐7 questions will become available

after the last lecture on Thursday

• You get a maximum of three attempts, with the

highest score counting

• There’s a total of 11 quizzes, counting for a

total of 11% of the final grade

• The deadline is by Friday next week midnight

If you cannot correctly solve quiz questions, it

is unlikely you will pass the exam!

6

Exams

• Two take home midterms for 14% of grade

each

– Week 6/ Friday April 13 covering weeks 1‐5

– Week 12/ Monday May 21 covering weeks 6‐10

– You will need to be connected to internet at

designated time

– All students take exam at same, no designated

location

• The final exam counts for 50% of the grade

– On UNSW campus in the summer term

examination period

7

MyFinance Lab

• Quizzes and Exams will be delivered via

MyFinance Lab

• Wide variety of worked excel examples are

available

• Many videos to illustrate concepts

• Financial calculator and financial news

8

Today’s learning outcomes

• By the end of this lecture, you should

– be familiar with the basic set‐up of bonds

– be able to price a bond via no‐arbitrage

conditions (arbitrage pricing)

– be able to find the present value of a bond via

discounting future cash flows and link it to the

logic of arbitrage pricing

– be able to understand yield‐to‐maturity (YTM)

and other related yield/return measures and

calculate them

9

What is a bond?

A bond is a To repay the money, the

certificate showing borrower has agreed to

that a borrower make interest and

owes a specified principal payments on

sum designated dates

10

Bond Example

11

Formal definition of bond

• Essentially a borrowing‐lending contract

– Three key parameters of a typical borrowing‐lending

contract: principal, maturity, and interest rate

• A bond is a claim on some fixed future cash flow(s), CF

– The bond matures at the time of its last cash flow, T

– Typically a “large” cash flow at maturity. We call this the

par value or face value (FV)

– There may be a series of smaller cash flows before

maturity. We call these coupons. There may be zero, one

or more coupons in a given year

– The sum of the annual coupons is often expressed as a

fraction of the FV, e.g. 5 %. We call this the coupon rate

(C). Let’s denote the actual coupon, e.g. $5, with ct, where

t is the period in which we get the coupon

12

Cash flows of a bond

• This figure illustrates the cash flows of a

bond with a FV of 100 and a yearly coupon

of 5

‐P c1 c2

FV

‐91.3 5 5

100

13

Default risk

• That somebody promises to pay you some

money doesn’t necessarily mean they will

your cash flows is called default risk

will generally ignore it in this course, i.e.

assume default risk is zero

14

Other frequent assumptions

• No transaction costs

• Complete markets

– Compare this to the assumption of vacuum in

classical mechanics

15

Two approaches to pricing

• Fundamental pricing

– Prices are set in a supply‐demand equilibrium

– The properties of an asset tell us what that price is likely to

be

– We will use this approach when pricing stocks later in the

course

• Arbitrage pricing

– Replicate the future cash flows of an asset with a portfolio of

other assets with known prices (replicating portfolio)

– Under no‐arbitrage condition, the price of the asset under

question should equal to the market value of the replicating

portfolio

– We will use this approach when pricing bonds and

derivatives

16

What is arbitrage?

• An arbitrage is a (set of) trades that generate zero

cash flows in the future, but a positive and risk free

cash flow today

– This is the proverbial “free lunch” or “money machine”

• A simple example exploits violations of the law of

one price, e.g. an identical bond selling for two

different prices

– Simultaneously buying the cheap bond and selling the

expensive bond would be an arbitrage trade

• All arbitrage pricing is priced based on the same

principle

– No‐arbitrage: securities with identical cash flows should

have the same price in the equilibrium (i.e., no ‘free

lunch’)

– but the trades are (slightly) more complex 17

Replicating portfolios

• We typically rely on a portfolio of assets that

exactly mimic the cash flows of some other

asset

• We call such portfolios replicating

portfolios or synthetic assets

• Arbitrage pricing is all about constructing

replicating portfolios using assets with

known prices

18

Example: Pricing a zero‐coupon

bond

• How would you price the risk‐free one‐year

zero‐coupon bond below?

t t+1

Bond A

P=? 100

19

Example: Pricing a zero‐coupon bond

future cash‐flow with some appropriate

discount rate, y, to get the present value

100 100

PA 90.9

1 y 1.10

20

Example: Pricing a zero‐coupon bond (cont.)

• The appropriate discount rate, y, is the return we

could have earned at some alternative investment

with the same risk

– Let’s say there’s a bank where you can lend and borrow

money at 10% interest

• We want to make a synthetic version of the bond,

i.e. some investments that mimic its cash flows

exactly

– In this simple example we can just put some amount of

money, M, in the bank.

– After one year in the bank account earning 10%

interest, it should have grown to match the bonds cash

flow of $100

– We must have: 1.1M 100

100

M 90.9 21

1.1

Pricing a zero‐coupon bond:

Exploiting the mispricing

• What if the bond price differs from that, say, $80.9?

– The $90.9 bank deposit replicates the bonds cash

flow (is a synthetic bond) but has a different price

expensive (in this case the synthetic)

instrument

– “Selling” a bank deposit means borrowing the

money

– In the discussion of arbitrage pricing, often we need

to adopt Short selling (or shorting) strategies on

instruments (i.e., selling securities you don’t hold)

22

Pricing a zero‐coupon bond:

Cash flows of arbitraging strategy

• Today we borrow $90.9 and buy the bond

for $80.9. We are left with $10.

exactly enough to repay the loan. We have

zero net cash flow.

entire scheme is an arbitrage trade

23

Arbitrage pricing:

How arbitrage affects prices?

• In practice smart people will identify arbitrage

opportunities and trade on them

• This will increase the demand for the bond and

raise its price until no further arbitrage trades

are possible, i.e. until prices are in equilibrium

• In this course we are interested in finding

those equilibria, e.g. arbitrage‐free prices

• We cannot say whether it was the bond price or

the bank’s interest rate that was wrong

• We can only say (and only care) if the prices

are internally consistent

24

Arbitrage pricing: general case

‐P c1 c2 ct cT

FV

want to price

CF‐stream must be the same as the price of

the replication

25

Arbitrage pricing: general case (Cont.)

• The bond is just a combination of future cash flows

• Replicate each cash flow: for example, $5 in year 3,

by depositing a specific amount of money in the

bank which will give you $5 in 3 years

• Together, all deposits (T deposits for T cash flows)

will form a replicating portfolio

• Note that the interest rate we get for each deposit

may be different from each other (i.e., interest rate

for 1‐year deposit may differ from 2‐year one).

– To indicate the maturity of an interest rate we typically

use a time index: yt

26

Arbitrage pricing: general case (Cont.)

• Replicating a cash flow of ct at time t

– Today, deposit Mt such that Mt(1 + yt)t = ct

– Find that Mt = ct /(1 + yt)t

– Today, deposit MT such that MT(1 + yT)T = FV + cT

– Find that MT = (FV + cT)/(1 + yT)T

equal to price

P = M1 + M2 + … + Mt + … + MT

= c1 /(1 + y1)1 + c2 /(1 + y2)2 + … + ct /(1 + yt)t + … +

(FV + cT)/(1 + yT)T 27

Arbitrage pricing and discounting

• We say that P is the present value, PV, of the future

cash flows

called discounting

– The market determines the appropriate interest rates

for all future horizons, yt

– The price of a bond (or indeed any financial asset) is the

sum of the present values of its future cash flows

– We are typically not explicit with the entire arbitrage

argument, but you can see the connection from previous

discussions

28

Bond price and yield to maturity

• Examples of bond price quotes

– http://www.asx.com.au/asx/markets/interestRateSecurityPrices

.do?type=GOVERNMENT_BOND

29

Pricing formula and yield‐to‐maturity

• From our previous discussions, we know

that the price of a bond could be determined

by discounting future cash flows:

– P = c1 /(1 + y1)1 + c2 /(1 + y2)2 + … + ct /(1 + yt)t

+ … + cT/(1 + yT)T + FV/(1 + yT)T

determined by the market, i.e., essentially by the

supply and demand of investments producing

cash flows in year t (with identical risks as

those from this bond)

30

Pricing formula and yield‐to‐maturity (cont.)

• Assuming constant interest rates (discounting rates):

• P = c1 /(1 + y)1 + c2 /(1 + y)2 + … + ct /(1 + y)t + … + cT/(1 + y)T

+ FV/(1 + y)T

– Note that in practice interest rates are not constant

– Instead we take P as given and define y as whatever interest rate

satisfies the equation above. Expressed on an annual basis, we call

this interest rate the yield‐to‐maturity (YTM, although we often just

denote it y)

– Hence YTM essentially summarizes all future interest rates

determining the bond price. And each bond has its own YTM.

most bonds), then

c 1 FV

P 1

y 1 y T 1 y T

– Don’t worry about this formulae. At most I will test up to T=3, and

you can easily do the calculation with the general formulae above.

31

YTM and bond prices

• This graph shows the price of a 30‐year

bond with a FV of $100 and a coupon rate of

10% for different YTMs

350

300

250

200

Price

150

100

50

0

0% 5% 10% 15% 20% 25%

YTM

32

YTM and bond prices (cont.)

• The bond price decreases with the YTM

• When YTM = C = 10 %, P = FV = $100

– When P = FV (C = YTM), the bond trades at par

– When P < FV (C < YTM), the bond trades at a

discount

– When P > FV (C > YTM), the bond trades at a

premium

YTM, when the YTM is high 33

YTM and realized holding‐period return

• YTM does not necessarily (actually not in

most cases) equal realized holding period

returns

• Realized bond returns over a year t

– Rt = (Pt+ct)/Pt‐1 – 1, or Pt‐1*(1+ Rt) = Pt+ct

– Prices at end of t (Pt) or t‐1 (Pt‐1) are

determined as the present value of future cash

flows – i.e., discounting future cash flows with

YTM at the respective time

– And YTM could (and will) change over time

(depending on the market interest rates for all

future horizons at each time)

34

Realized compound yield

0 1 2

Bond A

c

FVA

0 1 2

Bond B

c c

FVB

yields of the two bonds above, which have the same

YTM

• For a given investment horizon (like 2‐years), cash

flows from investing in two bonds will differ, since

bond B pays a coupon at time 1

• That coupon will have to be reinvested to make the

cash flows at the end of time 2 comparable

35

Realized compound yield (cont.)

• If the coupon can be reinvested at an interest

rate that equals the YTM, the time two cash

flows will be equal

when the reinvestment rate is different from

the YTM

– Collect all cash flows at the maturity of the bond

– Solve for the annualized return by dividing by the

price

Realized compound yield ‐ Example

• Assuming the following bond parameters

0 1 2

– FV: $100 face value Bond

96.62 10 10

– TTM: 2 years of time to maturity 100

– C: $10 annual coupons

– YTM: 12% yield to maturity (you can do the calculation

and find a price of $96.62)

– Suppose we can reinvest the year 1 coupon at 10%

– The resulting (aggregate) cash flow at time 2 would be

CF2=100 + 10 + 10(1+0.1) = 121

– The realized compound yield would be:

(121/96.62)1/2 – 1 ~=11.9%.

• If the coupon can be reinvested at an interest rate that

equals the YTM, then the realized compound yield is

just YTM.

– But realized compound yield is very useful for comparing

two bonds when reinvestment rates differ from YTM. 37

An alternative interpretation of YTM

• Suppose you could reinvest all coupons at an

interest rate that equals the YTM

• The realized compound yield, i.e. your investment

return at the maturity of the bond, would equal the

YTM

• Although this is a common interpretation of the

YTM, the concept of YTM does not make any

assumptions on reinvestment rates.

– reinvestment rates will be determined by the market

and realized in the future

– YTM is determined by the (expected) interest rates for

all future horizons)

38

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