You are on page 1of 38

Lecture

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)

• There will be videos that more or less


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

• The risk that you will be unable to collect


your cash flows is called default risk

• This is very important in practice, but we


will generally ignore it in this course, i.e.
assume default risk is zero
14
Other frequent assumptions
• No transaction costs

• Constant interest rates

• Complete markets

• These are all true within our model


– 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

• You may already know how to discount the


future cash‐flow with some appropriate
discount rate, y, to get the present value

• Assuming that y = 10% you’d get


100 100
PA    90.9
1  y  1.10

• What is the economic logic behind this?

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

• We buy the cheap instrument and sell the


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.

• In one year the bond pays us $100 which is


exactly enough to repay the loan. We have
zero net cash flow.

• Our “free” $10 is an arbitrage profit and the


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

• Strategy: Replicate the entire CF‐stream we


want to price

• For there to be no arbitrage, the price of the


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

• Replicating the cash flow at maturity, time T


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

• Our complete strategy costs – which should be


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

• This process of calculating the PV of future CFs is


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

– Appropriate discount rates, for example, yt, are


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.

• If we further assume annual coupons are equal (as in


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

• The price is less sensitive to changes in the


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

• Suppose that we are interested in comparing the


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

• The realized compound yield is a useful concept


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