FIXED INCOME SECURITIES

A. Introduction

The title “fixed income securities” normally refers to debt style securities. They
can differ in many respects:
Short (<1 yr)(T-bill, CDs, Commercial Paper)
(i) Term
Long (>1yr) (T-bill, Corporate Bonds etc.)

Treasury (national Taxing Authority)

States, municipalities
(ii) Issuer corporate (banks, corporations)
Agencies, investment banks (asset backed securities)

Zero coupon
(iii) Coupon
Coupon

(iv) Indenture provisions (seniority, security etc.). These are restrictions placed
on the actions of the organization issuing the bond.

(v) Call provisions (ability of the issuer to buy back the bond at a predetermined
price).
(vi) Conversion provisions (conversion of the bond to a pre-specified number of
shares).

B. Sources of Risk to the ownership of fixed income securities

True of Bonds
Issued by Federal True of
Taxing Authority other bonds
______________ ___________

Interest rate price risk Y Y

Default risk N Y
Inflation risk Y Y
Reinvestment risk Y Y
Liquidity risk N Y
Call risk N Y
Conversion risk N Y

For the moment we will focus on (default) risk free U.S. Treasury Securities

1
C. Objectives:

(1) To understand the relationships among the prices of risk free bonds of various
maturities;
(2) To understand the implications of these relationship for project evaluation;
(3) To understand what current bond prices imply for expected future interest rates; and
(4) To understand how to manage interest rate risk.

Kinds of Debt Securities

 Money Market Instruments (i.e., Short-Term Debt Securities)

Treasury Bills
Commercial Paper
Certificates of Deposit (CDs)
Money Market Certificates (MMCDs)
 Bonds (i.e., Long-Term Debt Securities)
Treasury bonds
Agency bonds
Municipal bonds
Corporate bonds
Mortgage-backed bonds
Convertible bonds
 Characteristics of Debt Securities
Type of issuer
Maturity
Coupon and Principal
Yields (Current and Yield-to-Maturity)
Call and Refunding Provisions
Sinking Fund Provision
Seniority, Security, and other indenture provisions
Conversion Provision
Coupon Adjustment Provision

Overview of Risks of Debt Securities

 Interest Rate or Price Risk

Yields Rise  Prices Fall  Capital Loss
Yields Fall  Prices Rise  Capital Gain
 Reinvestment Risk
Sources:
Interim Cash Flows: Coupon or Principal Payments
Redemption Value of Bond if/when the bond is sold
Interest on Previous Coupon Reinvestments
Interest Rates Rise  Interim Cash Flows  Reinvestment at a Higher Rate
Interest Rates Fall  Interim Cash Flows  Reinvestment at a Lower Rate

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 Default or Credit Risk
Risk of default on contractual interest or principal payments
Risk of delay in making contractual interest or principal payments
 Call Risk
 Inflation or Purchasing Power Risk
 Marketability or Liquidity Risk

Sources of Risk in Fixed Income Securities

 The principal amount, the promised coupon payments, and the promised dates of
these payments are known in advance for a fixed coupon bond. These quantities
are not known in advance for adjustable-rate instruments like floating rate notes.
 Bond prices vary inversely with bond yields, generating uncertain capital gains
and losses for bonds not held to maturity
 The rates at which future coupon payments are reinvested vary, creating uncertain
future values for bonds held more than one period
 Callable bonds or mortgage-backed securities have uncertain principal repayment
dates
 Most bonds have default or credit risk, creating uncertainty about both timely and
eventual payment of principal and interest. This risk is minimal for the bonds of
many governments.
 Bond markets are far from perfectly liquid, creating uncertainty about the price at
which one can actually liquidate a position.

Bond Market Price Quotation Conversions

 Bond, Note, and Bill prices are usually quoted per $100 of face value though they
are issued in $1000 units.
 They trade in dealer markets with a spread between the bid and offer price (1/32
for liquid treasuries)
 Treasury bills are sold on a discount basis:

Discount = Face value – Market Price.

 Treasury bond prices are quoted flat but buyer pays the full price. They are
quoted in units of 1/32 or 1/64. Corporate bonds are similar, but prices are
usually quoted in units of 1/8.

 Definitions:

Flat price = present value of future coupon and principal payments

Accrued Interest = Time since last payment / Time between

paymentsCoupon

3
 Full Price = Flat Price + Accrued Interest

 Bond and Bill prices are also quoted on a yield basis

FIXED INCOME SECURITIES AND THE EVALUATION OF RISK FREE PROJECTS

(ASSETS)

A. Introduction and Motivation

1. We are interested to determine the cost of capital, rp, appropriate for a

given project, so that we can compute its NPV:
T P
CF t
NPV =−I 0 + ∑ t
t =0 ( 1+r P )

This cost of capital should be the ROR on securities which represent title to cash
flows with risk equivalent to the project’s cash flow risk.

For the moment we’ll focus on ‘risk free projects.’ for which the equivalent (in
the above sense) assets are U.S. Treasury Securities (Our remarks will apply to the
government bond markets of most developed countries). It is the relationship between
yields and prices of U.S. Treasury Securities of various maturities that will concern us
first. In this discussion we will see a nice interplay between the two asset pricing
perspectives introduced in the first class. This interplay will lead us to the answer to the
question: How should risk free cash flows be discounted?

For risk free assets the measurement problems associated with the IRR and RRR
can be avoided, in a manner that will be apparent shortly.

B. “Zero Coupon” or “Discount” Bonds and the Term Structure of interest

rates

1. Cash flow pattern of a “Zero”

t=0 1 2 … T
-P0 MVT
price today promised maturity
value of bond

“Zeros” are U.S. treasury securities, which make no interest payments. They go
under the title of “bills” and normally have a time-to-maturity of less than one year.

2. The ROR to ownership of such a bond, r, is computed in the standard way:

4
 MV T
P0 =
( 1+r )T
Note that since there are no intermediate cash flows to reinvest, the IRR & RRR coincide:
there is no ambiguity in defining the rate of return on such a security.

3. “Zero Coupon” bonds define date-contingent securities: securities that pay $1.00
at some specific future date and nothing at any other time.

4. Definition: the “term structure” is the relationship between the IRR and time to
maturity for risk free zero coupon bonds of progressively greater maturities.

The “term structure” is simply a series of interest rates {r1,r2,…, rN }

Corresponding to the yields on zero coupon risk free bonds of progressively greater
maturities. These rates typically approximately observe one of the following patterns:

IRR IRR IRR

1 2 3 T 1 2 3 T 1 2 3 T

5. For risk free treasury coupon bonds, there is the analogous notion of a
“yield curve.” For a coupon bond, the payment pattern is as follows:

T=0 1 2 3 … T
-P0 int1 int2 int3 intT+MVT
‘coupon’ or interest payments maturity or
face value

We can also plot the IRR’s for such bonds, versus their time to maturity. One of the
same three general patterns is again typically observed:

IRR on IRR on IRR

coupon T-bonds coupon T-bonds coupon T-bonds

5
 1 2 3 T 1 2 3 T 1 2 3 T

The problem with this idea is the old reinvestment rate problem of the IRR: the
indicated rates of return are not measured correctly from the investor perspective.

This is not the true sense of the term structure, although the expression “term
structure” is often applied (carelessly) anyway to the case of coupon bonds.

6. Review of the bond tables (see Appendix).

C. Equilibrium Pricing Relationships between Discount and Coupon bonds

We have observed that a reasonable sense of financial equilibrium requires that

there be no arbitrage opportunities. An absence of arbitrage opportunities forces a
particularly close and identifiable relationship between risk free discount bonds
and coupon bonds.

1. This idea: Consider a risk free 8% coupon bond, with face (maturity) value $1,000
maturing in 5 years; the cash flow pattern is

T=0 1 2 3 4 5
P0 80 80 80 80 1080=1,000+80

Suppose we also observe the following discount bond prices:

Bond Price cash flow pattern

t=0 1 2 3 4 5 IRR
1 yr. disc. $920 -920 1,000 .087

2 yr. disc. $860 -860 1,000 .078

3 yr. disc. $800 -800 1,000 .077
4 yr. disc. $720 -720 1,000 .086
5 yr. disc. $640 -640 1,000 .094

Consider the following portfolio

(.08 1-yr. Bond, .08 2-yr bond, .08 3-yr bond, .08 4-yr. bond, 1.08 5-yr. Bond)
For this portfolio we can figure out the cash flow pattern.

Bond Price cash flow pattern

t=0 1 2 3 4 5

.08 1-pd bond .08(920)= -73.6 80

.08 2-pd bond .08(860)= -68.8 80
.08 3-pd bond .08(800)= -64 80

6
.08 4-pd bond .08(720)= -57.6 80
1.08 5-pd bond (1.08)(640)= -691.2 1,080

Thus, this portfolio, in the aggregate, has exactly the same cash flow pattern as
the coupon bond. In a well-functioning securities market, therefore, the coupon bond and
the portfolio of discounts bonds should sell for the same price (claims to equal cash flows
sell for equal prices).
Pcoupon bond = Pportfolio = .08(920)+.08(860)+.08(800)+.08(720)+1.08(640) = $955.

This is the price for which the coupon bond must sell if there are to be no arbitrage
opportunities, the ‘so called’ no arbitrage price. We can use arbitrage methods because
of the all payments are known with certainty.

2. How is this related to the term structure?

Pcoupon bond = Pportfolio = .08(920)+.08(860)+.08(800)+.08(720)+1.08(640)

( prices of ¿ ) ( the bonds ¿ ) ( define the ¿ ) ¿ ¿¿

or
¿
80 80 80 80 1080
Palignl ¿ coupon ¿bond ¿= + + ¿
1+r 1 ( 1+r 2 ) ( 1+r 3 ) ( 1+r 4 ) ( 1+r 5 ) 5
2 3 4

This says that pricing the coupon bond as a portfolio of discount bonds is equivalent to
discounting the coupon bond’s cash flow at the term structure.

3. Most importantly, these discount bond prices define the prices of what we shall call
date-contingent claims. To say that a sure promise to pay $1,000 in period 1 sells for
$920 today (pd 0) is equivalent to saying that the price today (t=0) of $1.00 to be received
in period 1 is $.92.

t=0 1
-.92 1.00

We call this a date-contingent claim as it is a security, which pays $1.00 in period

1 irrespective of the state occurring at that date.

The full set of discount bond prices defines a full set of date-contingent claims prices

t=0 1 2 3 4 5
-.92 1.00 (.92=1/(1+r1))
-.86 1.00 (.86=1/(1+r2))

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 -.80 1.00 etc.
-.72 1.00
-.64 1.00
We can thus also price bond as
Pbond =80 × 0.92+ 80 ×0.86+ 80× 0.80+80 ×0.72+1080 × 0.64=$ 955

(number of dollars in period 2) (price in t=0 of $1.00 in pd 2) etc.

4. Remark: Any risk free asset (can be viewed as a security which, in turn,) can be
expressed as a portfolio of risk free discount bonds. But this says that any risk free cash
flow should properly be discounted at the term structure.

t=0 1 2 3 … T
CF1 CF2 CF3 CFT

PV CF =CF3 ¿ ( Price of a 3 pd¿ )( contigent claim ¿) ¿¿

3 ¿
number of 3rd period
contingent claims
needed to replicate
CF3

So we discount risk free cash flows at the term structure. To discount at the term
structure is to view a risk free cash flow as a coupon bond and to price it accordingly as a
portfolio of discount bonds.

Remark 1: If we discount cash flows at a constant rate, rf, e.g.,

T risk free
CF t
NPV =−I 0 + ∑ t
t =0 ( 1+ r f )
we are assuming the term structure is flat.

Remark 2: Preview: we will, in general, adopt the following procedure for discounting
risky cash flows.

t=0 1 2 3 T
-I0 CF1 CF2 CF3 CFT
~ ~ ~
E C F1 E C F2 E C FT
NPV =−I 0 + + + .. .+
1+ r 1 + π 1 ( 1+ r 2 + π 2 ) 2 ( 1+ r T + π T )T

8
 T
i.e., we add risk premia, { π }t=1 , to the risk free discount rates (the term structure) to
reflect the cash flow risk. In the above abstraction r1+μ, reflects the rate of return on
securities, which pay off only in period t and with cash flow risk similar to CFt.

D. Constructing the Term Structure in Practice.

Although the term structure is defined by the prices of discount bonds of all
maturities, the U.S. Treasury does not issue pure discount bonds of more than one year
term. Rather, it issues coupon bonds of a variety of maturities.

But just as we priced coupon bonds as portfolios of discount bonds, we may go

the other direction and uncover the embedded discount bond prices provided we have
enough coupon bonds of differing maturities with which to work. That is, we want to
construct the no arbitrage prices of discount bonds, were they to exist.

We illustrate this procedure as follows:

1.An example:

Suppose, we observe treasuries of one, two, three, and four-year maturity all selling at par
with, respectively, yearly coupons of 6%, 6.5%, 7.2% and 9.5%. The associated cash
flows are as follows:

t=0 1 2 3 4

-100 106
-100 6.5 106.5
-100 7.2 7.2 107.2
-100 9.5 9.5 9.5 109.5
(per $100 of face value).

1. Let us construct the term structure (r1, r2, r3, r4) from this information.
r1: since the 1yr bond sells at par,

106
100= ⇒ r =6 %
1+r 1 1
(since the bonds sells at par, they are selling for $100/$100 of face value)

r2: 2 yr bond are priced according to

9
 6 . 5 106 .5
100= +
1+r 1 ( 1+r )2
2
6 . 5 106 . 5
100= + ⇒ r 2 =0 . 065163 or 6 . 5163%
1 . 06 ( 1+ r 2 )2

r3: 3 yr bond are priced according to

7.2 7.2 107. 2

100= + +
1+r 1 ( 1+r 2
( 1+r 3 )
3
2)
7.2 7.2 107 . 2
100= + + ⇒ r 3 =0 . 072644 or 7 .2644%
1 . 06 ( 1 .065163 ) ( 1+r 3 )3
2

r4: 4 yr bonds are priced according to

9. 5 9 . 5 9 .5 109 . 5
100= + + +
1+r 1 ( 1+r 2 ) ( 1+r 3 ) ( 1+r 4 )4
2 3

9. 5 9 . 5 9.5 109 . 5
100= + + + ⇒r 4 =0 . 09935 or 9. 935%
1 . 06 ( 1 .065163 ) ( 1 .072644 ) ( 1+ r 4 )4
2 3

The procedure just illustrated is a systematic way of constructing the true

structure, in this case sequentially. All that we need to do is to secure the prices of
risk free coupon bonds of progressively greater maturity.

Note that this procedure depends upon the existence of coupon bonds of
successively greater maturity of exactly one year. This may not, in practice, be the
case and a certain type of interpolation called for.

Note also that this procedure amounts to solving the following linear program for
x 1 , x 2 , x 3∧x 4

100=106 x 1
100=6.5 x 1 +106.5 x2
100=7.2 x 1+ 7.2 x 2 +107.2 x 3
100=9.5 x1 +9.5 x 2+ 9.5 x3 +109.5 x 4

1 1
x 1= , x 2= ,
1+r 1 ( 1+r 2 )
2
where etc.

E. Constructing Discount Bonds

1. The prior example described how investors could infer the term structure
from coupon bond prices. Given this constructed term structure investors

10
 could then also straightforwardly infer the corresponding discount bond
prices. For example,

1000 1000
P1= = =$ 943 . 4
1+r 1 1 . 06
1000 1000
P2 = = =$ 881. 39
( 1+r 2 ) ( 1. 065163 )2
2

1000 1000
P3 = 3
= 3
=$ 810. 28
( 1+r 3 ) ( 1. 072644 )
etc.

2. But these bonds are not necessarily traded. How could we in effect create
them as traded securities?

Let’s create the two-year discount using the one and two-year coupon bonds.

t=0 1 2

we have: -1000 1060

-1000 65 1065

we want: -881.39 1000

3. Solution:

Step1. To create the 1000 at t = 2 we need to acquire 1000/1065 = 0.939 two-

year bonds. This alone would give the cash flow:

t= 0 1 2
0.939 2-yr bond -939.00 61.035 1000

But we need to eliminate the $61.03 payment. We do this by shorting

61.035/1060 = 0.0576 one-year bonds.

Altogether, this yields:

t= 0 1 2
long 0.939 2-yr bond: -939.00 61.035 1000
short 0.0576 1-yr bond: +57.6 -61.035
net: -881.40 0 1000

as desired.

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 F. The Significance of Arbitrage

Our results so far have depended critically on the idea that in a well-functioning
securities market, claims to equal cash flows should sell for equal prices. The market
mechanism that forces such pricing consistency is “arbitrage” – making profits from
security mispricing. We would expect that the consistency in prices of securities is
guaranteed by arbitrageurs since for these securities payments in all future states are
known.

1. The idea is very simple: if a bond is overpriced, its cash flow can be replicated more
cheaply by some other portfolio of securities, this suggests we should:

(i) borrow the security-bond in this case – which you believe is

overvalued and sell it (short sale),
(ii) pay any interest or principal payment during the period the
security is borrowed. By replicating its cash flow with a long
position in the lower priced securities.
(iii) Buy an identical security to the one originally borrowed,
hopefully at a lower price, and return it at the required time.

An “illustration”: consider a risk free coupon bond, currently priced at $1,100 with title
to the following cash flows:

T=0 1 2
80 1080 (8% coupon)

Suppose we observe also that

The price of a 1-pd discount bond is $920, and

The price of a 2-pd discount bond is $860

P theoretical coupon bond = .08(920)+1.08(860)=1002.4 the coupon bond is thus relatively

overpriced.

Consider the following trades:

1. Sell short: 1,000 coupon bonds; revenue = 1,000x1,100 =1,100,000

In doing so, we have obliged ourselves to the following cash flow

t=0 1 2
80,000 1,080,000

2. Buy 80 1-pd bonds, 1080 2-pd bonds:

Cost: 80(920)+1080(860) = -1,002,400

12
This given cash flow of
t=0 1 2
80,000 1,080,000
so we are fully protected

Profit = $97,600

Of course, the expectation is that the coupon bond will fall in price, so that we
could liquidate our discount bond position, repurchase the 1,000 coupon bonds at a lower
price than at which they were sold short, and return them to the lender.

3. Furthermore, no matter what equilibrium prices are achieved, the arbitrageur will
earn the full $97,600.

For example, suppose the equilibrium prices become:

t= 0 1 2
-930 1000
-880 1000
-1024.80 80 1080

(This is an equilibrium since 1024.80 = .08(930)+1.08(880)

Profits
Coupon bond: (1100-1024.80)x1000 = 75,200
1 yr discounts (930-920)x80 = 800
2 yr discounts (880-860)x1080 = 21,600
______
Total 97,600

This process will force securities to be priced consistently with one another, such profits
can be made so long as a price discrepancy exists. Notice that the arbitrageur invested
zero capital of his own.

G. The Relationship Between the Yield Curve of Coupon Bonds and the Term
Structure of Discount Bonds: Implications for Capital Budgeting and Project
Evaluation.

Suppose we use the yield curve for U.S. Treasury coupon bonds as an approximation
to the true term structure in the evaluation of a risk free project. What sort of bias
will be introduced? First we must explore the relationship of the true term structure
to the coupon bond term structure.

13
(i) For a rising yield curve, the relationship is as follows:

r true term structure

“yield curve” of 5% coupon bonds

“yield curve” of 10% coupon bonds

T (maturity)

(2) Intuition: a risking term structure implies short term rates will be higher in the
future. Thus investors would prefer to receive their money sooner, in order to be able
to reinvest in at higher rates, and hence will find coupon bonds more attractive from
the total return perspective. So coupon bonds will sell for higher prices and hence
have lower IRR’s (higher the coupon, the lower the IRR)

(3) This intuition can be confirmed numerically. Consider a 4 yr 10% coupon bond,
and our example term structure r1=.08, r2=.10, r3=.13, r4=.14. The price of the 10%
coupon bond is:
100 100 100 1100
P= + + + =$ 895. 83
1. 08 1 . 12 1 .133 1 .14 4

Clearly, the IRR on this bond is less than 14%. So the yield curve of coupon
bonds must lie below the term structure of discount bonds.

(4)The opposite is true for a declining term structure.

“yield curve” of 10% coupon bonds

“yield curve of 5% coupon bonds

zero-coupon bonds (term structure)

T (maturity)

14
For a declining yield curve, future reinvestment rates will be lower, so investors do not
want payments to come quickly. Thus zero coupon bonds will have the highest prices
and lowest yields.

(5) Implications for Capital Budgeting: If we use the yield curve on interest bearing
bonds as a substitute for the true term structure, what bias will be introduced into
capital budgeting evaluations?
true term structure coupon yield curve

coupon yield curve

true
term structure

T T
to use the coupon yield curve to use the coupon yield curve
is to overstate the is to understate the
project’s value (NPV) project’s value (NPV)

H. Summary

You will recall our two perspectives on asset pricing. Both dealt with the question of
when an asset is correctly priced relative to other assets in its risk class.

(i)Assets within the same risk class are correctly priced provided claims to equivalent
cash flows sell for equal prices.

(ii)Assets within the same risk class are correctly priced provided they earn the same
expected rate of return.

For risk free cash flows we have demonstrated that arbitrage will guarantee the
equivalence, in the following sense, of these perspectives.

Risk free assets are correctly priced if they are priced as an equivalent portfolio of
discount bonds. That is so if and only if their cash flows are discounted at the term
structure and thus that they pay the ROR implied by the term structure. But what
ROR is implied by the term structure? That is our next topic. What we are doing is
pricing each future cash flow element individually, by discounting it at the ROR on a
security with the exact same cash flow pattern (risk and timing), i.e., a discount bond
of the same time to maturity.

15
 Mention should be made at this point that the creation of discount bonds by
separating the interest and principal payments of Treasury bonds and selling the
separately is an example of new security creation. It is always motivated by the
desire of investors to be able to purchase securities (in this case risk free ones) with
payment differing from what is currently available.

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 Appendix A: T-Bills (Discount Bonds)

(i) (ii) (iii) (iv) (v) (vi)

July 23 ’2017 171 5.09 8.07 .02 5.07

(i) Bond matures on July 23, 2017

(ii) 171: Days remaining until maturity from date of this quote
(iii) Bid/Ask: These are yields computed on Bid/Ask prices. Since the ask price is
higher, its yield is lower.
(iv) These yields are related to prices via the following formula.

F−P 360
ask yield
=i=
F ( )
N
or
N
P=F− iF
360
where P is the current price, F is the face value of $1000 and N is days to maturity.

In the above example:

P = 1000-(171/360)(.0507)(1000) = $975.9175

(v) The change is measured relative to “ask yield;” +.02 means ask yield rose .
02%.

Appendix B: Coupon Bonds

(i) (ii) (iii) (iv) (v) (vi)

7¾ Nov. 19n 104:03 104:05 +1 5.32

(i) 7 ¾: This is the coupon rate, i.e., $77.50 interest / year (7 ¾ % x 1000) paid as
$38.75 on Nov. 15
$38.75 on May 15

(ii) Nov. 19n: maturity date, actually Nov. 15, 2019; the “n” indicates a note

(iii) 104:03: This is the Bid Price: Dealers are willing to buy at this price
104:03 is to be read
104 3/32 per $100 of face value, or
Bid Price=104 3/32 x 10=$1040.9375

(iv) 104:05: Ask Price: Dealers are willing to sell at this price. It is the price at
which a transaction could occur
Ask Price = 104 5/32 x 10 = $1041.5625

(v) +1: Changes in the Ask Price from previous pay close of trading:

17
 +1 implies a change of 1/32 / 100 of face value or .03124/100 of value or
$.3125 dollars

Deriving the Ask Yield

A. Measurement particulars: For U.S. Treasury securities the yield to maturity

(IRR) is reported daily in the newspaper. Since interest and principal payments do
not necessarily fall on whole numbers of periods measured from the date of return
quotation some adaptation of the standard IRR formula is required. We illustrate this
in an example presented above where we compute the IRR on a Treasury bond with a
7 ¾ coupon coming due on November 15, 2015 relative to its price on January 30,
2014 of $1041.5625.

(i) The computation: 7 ¾ bond due November 2015. (Government bonds normally
come due on the 15th of the month, if that date falls on a weekend, payment is made
on Monday immediately following.)

The annualized IRR (5.32%) is computed approximately as follows:

[purchase price PV[future cash flow (interest

(ask price)] + [accrued interest] = & principal) discounted at the

IRR]

a. Price
(104 5/32)/100x$1000/bond = 104.15625x10 = $1041.5625

b. Accrued Interest: This bond pays interest on November 15 and May 15. Since the
last payment (Nov. 15, 2013), 76 days have passed.

76 77 .5
( )( )
182
×
2
=$ 16 . 18

6 months interest payment

c. Therefore:
38 .75 38 .75 1038 . 75
1041. 5625+16 .18= 106
+ 106
+. ..+
IRR IRR IRR IRR 106
182 1+ IRR
3

(1+
2 ) (
182 1+
2 ) (
182 1+
2 ) ( 1+
2 ) ( 2 )
where (106/182) is the fraction of period until next interest payment is made; i.e.,
from Jan. 31st to May 15th is 106 days.

Solve for IRR; obtain IRR = .0532

18
 It is referred to as the “bond equivalent yield.”

Appendix C: Strips

(i) (ii) (iii) (iv) (v) (vi)

Nov. ’19 ci 95:30 93:31 -1 5.37

(i) Nov. 15, 19 – Date Bond Matures

(ii) ci: this security is composed only of coupon payments

np: this security is composed only of the principal payment (It is a discount
bond)

(iii) Bid/Ask Prices – Same interpretation as Coupon Bonds, i.e., 95:31 for the
Nov. 19 ci Bond Ask Price means 95 31/32/100 of face value

(iv) Change: Same interpretation as coupon bonds, i.e., +1 means an increase of

1/32/100 of face value

(v) Ask Yield: IRR’s based on Ask Price (with semi annual compounding)

Appendix D: TIPS – Treasury Inflation Protected Securities

A. The Idea

Example: 5-yr. Bond, par value $1000, real coupon 3.5%, assume annual
payments.

T= 0 1 2 3 …

Inflation 0%

Principal 1000 1000 1000 1000

Coupon 35 35 35

Inflation 2%

Principal 1000 1020 1040.4 1061.21

Coupon 35.7 36.41 37.14
(.035x1020) (.035x1040.4)
Inflation 4%

Principal 1000 1040 1081.6 1124.86

Coupon 36.4 37.86
(.035x1040) (.035x1081.6)

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etc.
Good for retirement accounts: adjustment relative to CPI (lag 3 months); pay
tax on interest + accrued capital value increase.

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