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Interest Rate and Fixed Income PDF
Interest Rate and Fixed Income PDF
Interest rates are typically quoted on annual basis, even if the compounding
period is less than 1 year.
n compounding periods in each year
rate of interest r
r y·n
A invested for y years yields A 1 + n
2
Present value
Price p of a contract that pays c = (c0 , c1 , c2 , . . . , cN )
ck > 0 ≡ cash inflow, and ck < 0 ≡ cash outflow
4
Different lending and borrowing rates
Can lend at rate rL and borrow rate at rate rB : rL ≤ rB
ck
Portfolio: buy contract, and borrow (1+rB )k
for k years, k = 1, . . . , N
ck
Cash flow in year k: ck − (1+rB )k
(1 + rB )k = 0 for k ≥ 1
PN ck
No-arbitrage: price = p − c0 − k=1 (1+rB )k ≥0
Lower bound on price p ≥ PV (c; rB )
ck
Portfolio: sell contract, and lend (1+rL )k
for k years, k = 1, . . . , N
ck
Cash flow in year k: −ck + (1+rL )k
(1 + rL )k = 0 for k ≥ 1
PN ck
No-arbitrage: price = −p + c0 + k=1 (1+rL )k ≥0
Upper bound on price p ≤ PV (c; rL )
6
Bonds
Features of bonds
Face value F : usually 100 or 1000
Coupon rate α: pays c = αF /2 every six months
Maturity T : Date of the payment of the face value and the last coupon
Price P
Quality rating: S&P Ratings AAA, AA, BBB, BB, CCC, CC
Yield to maturity λ
2T
X c F
P= k
+
(1 + λ/2) (1 + λ/2)2T
k=1
7
Yield to maturity
Yield to maturity λ
2T
X c F
P= k
+
(1 + λ/2) (1 + λ/2)2T
k=1
But ... yield to maturity is a crude measure. Does not capture everything.