FINS2624 Lecture 1 T2 2021

UNSW Business School/ Banking & Finance
FINS2624 Lecture 1
Introduction to Bond Pricing and Term
Structure of Interest Rates I
Lecture Outline
q Bond characteristics
Ø Elements in pricing a bond
Ø Bond Cash Flows
q Bond pricing
Ø Arbitrage pricing
Ø PV of a bond – discounting future cash flows
q Yield / return measures

Ø Yield to Maturity (YTM)
Ø Holding Period Return
Ø Realised Compound Yield
q Introduction to the term structure of interest rates

Ø Yield Curve
Ø Inferring future interest rates
1
What is a Bond?
q A bond is a certificate specifying a debt obligation for a fixed sum between
the Issuer (borrower) and the Bondholder (lender)
Ø Issuers (borrowers) typically include corporates, Governments etc
Ø Bondholders (creditors) typically include fund managers
q Essentially a borrowing-lending contract where the issuer makes interest

and principal payments on designated dates to repay the debt obligation
Ø The Indenture is the contract between the issuer and the bondholder
describing the terms, conditions and protections for bondholders
q Default risk - risk that the issuer will not repay their debt obligations
Ø Bondholder is unable to collect all the expected cash flows from the bond
Ø While default risk is very important in practice it will generally be ignored
in this course
BKM 14.1
2
Characteristics Pricing Yield Term Structure
Bond Characteristics
q A bond is a claim on fixed future cash flows CF
q There are five key parameters in pricing a bond (P):
Ø Term (T): the period of time to maturity of the bond (ie when the bond
pays its last cash flow) ie the “term to maturity”
Ø Face Value (FV) or par value: the principal or loan amount of the bond,
typically repaid in full as one large cash flow at maturity
• Typically $1000 lots
Ø Coupon (C): series of smaller cash flows paid before maturity. These are
essentially interest payments
Ø Coupon frequency: the number of times per annum, the coupon is paid.
May be zero, one or more coupons in a given year
• Typically semi-annual
Ø Yield to Maturity (YTM): the actual (market) interest rate applied to
discount the cash flows from the bond (including principal and coupons)
BKM 14.1
3
Bond Cash Flows
q This figure illustrates the cash flows of a 2-year bond with a FV of 100 and
a yearly coupon of 5
We denote the
coupon ($5) as
Ct where t is
the time period
when we get
the coupon
q The sum of the annual coupons are often expressed as a fraction of the FV,
e.g. 5 %. We call this the Coupon Rate = C / FV
q Note that although coupons are treated as interest income to bondholders
the coupon rate is not necessarily equal to the YTM (see YTM discussion)
BKM 14.1
4
Approaches to Pricing
There are two approaches to pricing:
q Fundamental pricing
Ø Prices are set in a supply-demand equilibrium
Ø The properties of an asset tell us what that price is likely to be
q Arbitrage pricing
Ø Replicate the future cash flows of an asset with a portfolio of similar
assets with known prices (called the replicating portfolio or synthetic
asset)
Ø Under no-arbitrage condition, the market value of the asset we are trying
to price should equal the market value of the replicating portfolio
Ø We use this approach when pricing bonds and derivatives
BKM 14.2
5
What is Arbitrage?
q An arbitrage is a (set of) trade(s) that:
Ø Require no net capital outlay (zero net cash flow upfront) AND generate
positive but risk-free cash flow in the future
Ø Or alternatively, a positive and risk-free cash flow today with no net outlay
(ie zero cash flow) in the future
Ø The proverbial “free lunch”
q Law of one price states that two assets with the same payoff (identical cash
flows) should have the same price in equilibrium
Ø For example – two identical bonds should sell for the same price
Ø If not, simultaneously buy the cheaper bond and sell the more expensive
bond – this is an arbitrage trade
q All arbitrage pricing is based on the no-arbitrage principle (the law of one
price)
BKM 10.2
6
Arbitrage Example: Zero Coupon Bond
q Replicating portfolio (or “synthetic asset”): construct a portfolio of other
assets that exactly mimic the cash flows of the asset we wish to price
q Arbitrage pricing is all about constructing a replicating portfolio using assets
with known prices. With a replicating portfolio we can execute an arbitrage
and price the subject asset correctly
q Simple example: How would you price the risk-free one-year zero-coupon
bond below?
BKM 14.2
7
q From previous course work you would know we “discount” the future cash-
flow with some appropriate discount rate y to get the present value (if not
see the Lecture 0 slides)
q Assuming y = 10% then the price of Bond A is:
100 100
PA = = » 90.9
(1 + y ) 1.10
q The appropriate discount rate y is the return we could have earned on an
alternative investment with the same risk
q What would be a replicating portfolio for the bond ie an alternative
investment that mimics its cash flows exactly?
BKM 14.2
8
q Say there is a bank where you can lend and borrow money at 10% interest
Ø In this simple example we just put an amount of money M in the bank
Ø To replicate the bond, after one year in the bank account earning 10%, M
should have grown to match the bond’s cash flow of $100
Ø We must have:
1.1M = 100
100
M= » 90.9
1.1
q What if the $90.90 bank deposit replicates the bonds cash flow (is a
synthetic bond) but differs from the bond price
Ø For example, say the bond was trading at $80.90?
q What would we do?
BKM 14.2
9
q Arbitrage typically involves two trades: we buy the cheaper instrument and
sell (or short) the more expensive instrument (the synthetic in this case)
q In executing an arbitrage, we typically need to short sell (or short) a
security (i.e., selling a security we don’t own). We will expand on this later
q “Selling” a bank deposit means borrowing the money
q The arbitrage trade is as follows:
① Today: Borrow $90.90 from the bank: + 90.90
Buy the bond: - 80.90
Remaining Cash: + 10.00
② In one year: Receive bond principal (FV) + 100.00
Repay bank loan: - 100.00
Remaining (zero net cash flow): -
q Our “free” $10 upfront is an arbitrage profit
BKM 14.2
10
Arbitrage Achieves Price Equilibrium
q In reality, true arbitrage opportunities are rare and short-lived as traders
close asset mispricing by trading on them in significant quantities
q In our example, traders borrow from the bank to buy the bond. This will:
Ø é increase demand for the bond and raise its price
Ø é increase the bank borrowing rate (ie above 10%)
Ø continue until no further arbitrage trades are possible ie when the two
trades yield exactly the same payoff, and prices are in equilibrium
q We can not say whether it was the bond price or the bank’s interest rate
that was wrong. We can only say the prices are internally inconsistent and
violate the no-arbitrage principle (ie the law of one price)
q This course focuses on finding arbitrage-free price equilibrium
BKM 14.2
11
Arbitrage Pricing: General Case
q Arbitrage pricing also holds for coupon paying bonds
q Replicate the entire CF-stream we want to price
q The bond is just a combination of future cash flows (CFs)

Ø The bond price (P) is the sum of the present value (PV) of its future cash
flows (as it is for any financial asset)
Ø For there to be no arbitrage the PV of the CF-stream must be the same
as the PV of the replicating portfolio
Ø The process of calculating the PV of future CFs is called discounting
BKM 14.2
12
q Replicate each cash flow: eg if C2 is a $5 coupon in year 2, deposit a
specific amount of money in the bank which will give you $5 in 2 years
q Together, all deposits (T deposits for T cash flows) will form a replicating
portfolio
q Note that the interest rate we get for each deposit may differ (eg interest
rate for a 1-year deposit may differ from a 2-year deposit)
Ø The market determines the appropriate interest rate (or discount rate) for
each and every future time horizon
Ø To indicate the time horizon of an interest rate, we typically use a time
index: yt
BKM 14.2
13
q Replicating cash flows before maturity (coupons) at any time t:
Ct is a cash flow (coupon) at any time t (t = 1, 2, …, T-1)
Today: Deposit Mt such that Mt(1 + yt)t = Ct
The correct deposit amount Mt is therefore: Mt = Ct / (1 + yt)t
q Replicating the cash flow at maturity, time T:
Today: Deposit MT such that MT(1 + yT)T = FV + CT
The correct deposit amount Mt is therefore: MT = (FV + CT) / (1 + yT)T
q To execute the complete strategy therefore costs an amount equal to the
price of the bond:
P = M1 + M2 + … + MT-1 + MT
!! !" !#$! (&'# !# )
Therefore: P = ! + " +…+ # _! + #
"# $! "#$" "#$#$! "# $#
BKM 14.2
14
Example of Bond Price Quotes
www.asx.com.au
15
Yield To Maturity (YTM)
q As we saw, the bond price is derived by discounting its future cash flows:
q But how do we derive the appropriate discount rates yt ?

Ø These interest rates are determined by the market – essentially as a
result of the supply and demand for investments producing cash flows in
year t (with identical risks as those from this bond)
q Under constant interest rates, the bond price formula would be restated as:
!! !" !& !# &'
P = ! + "+ … + & + # +
"#$ "#$ "#$ "#$ "#$ #
This constant interest rate y that makes the present value of the bond’s
cash flows equal to its price is called the Yield to Maturity (YTM)
BKM 14.3
16
Yield To Maturity (YTM)
q Yield to Maturity (YTM)
Ø Bond’s internal rate of return
Ø YTM is the one average rate which results in the bond price
Ø Assumes that all coupons can be reinvested at the YTM
Ø Expressed on an annual basis, and denoted y
q How do we derive y?
Ø In the equation below where y is constant (from the previous slide), take
P as given and solve for y (typically with a financial calculator or excel):
!! !" !& !# &'
P = ! + " +…+ & + # + #
"#$ "#$ "#$ "#$ "#$
Ø To derive the YTM (y), the bond price (P) must be given
BKM 14.3
17
Bond Pricing as an Annuity
q Note that if we assume both the interest/discount rate (ie the YTM - y) and
the coupons are constant, we can significantly simplify the bond pricing
formula
q In this case, the bond pricing formula can be seen as an annuity stream
followed by a repayment of principal:
Annuity Factor PV Factor PV of
PV of Coupon Principal (Par)
Payments _𝑇 Repayment
1− 1+𝑦 _𝑇
𝑃=𝐶 + 𝐹𝑉 1 + 𝑦
𝑦
That is: Price = Coupon x Annuity Factor + FV x PV Factor

q Note that for this course, it isn’t essential to memorise this annuity formula.
At most we will test up to T=3, which can be done just as easily with the
basic, expanded bond formula
BKM 14.2
18
YTM and Bond Prices
q It is important to note that bond price always has an inverse relationship
with YTM (ie as YTM é P ê and vice versa)
q The graph shows the price of a 30-year bond with a FV of $100 and a
coupon rate of 10 % for different YTMs. It clearly shows the inverse
relationship between YTM and P:
350 Premium Bond:
300 P > FV (C > YTM)
250
200 Par Bond:

Price
150
P = FV (C = YTM)
100
50 Discount Bond:
0 P < FV (C < YTM)
0% 5% 10% 15% 20% 25%
YTM
BKM 14.3
19
YTM and Realised Returns
q If actual interest rates are constant and equal to the YTM, then the
annualized actual return over any holding period will be the YTM
q However, in reality this is rarely the case, and most of the time the YTM
does not equal the realized returns over a specific holding period because:
Ø Actual market interest rates do not equal the YTM
Ø Actual market interest rates do not remain constant and change over time
q Therefore we have measures for the actual return on a bond:

Ø Holding Period Return (HPR)
Ø Realised compound yield (which is simply the HPR annualised)
BKM 14.3
20
YTM and HPR
YTM HPR
q It is the annualized average q It is the rate of return over a
return if the bond is held to particular investment period (not
maturity necessarily annualized)
q Assumes one constant future q Allows for a changing future re-
re-investment rate investment rate
q Depends on coupon rate, bond q Depends on future interest rates
price, maturity, and face value and bond price at the end of the
holding period (if sold)
q All of these variables are
readily observable q Can only be forecast and is not
readily observable
BKM 14.3
21
YTM vs Realised Compound Yield
q If interest rates fall, coupons will
be re-invested at lower rates and
the return from holding the bond –
the Holding Period Return (HPR)
will be lower
q The annualised HPR for a bond
held to maturity is its realised
compound yield (sometimes
called simply “realised yield”)
q Consider a 2-year 10% coupon
$1000 bond purchased at par (ie
P0=$1000) with a reinvestment
rate of 10% and 8%:
BKM 14.3
22
YTM vs Realised Compound Yield
q Changes in rates affect the HPR (and the price of the bond) because
coupons are re-invested at different rates to the YTM
q In the example from the previous slide the HPR is:
𝑻𝒐𝒕𝒂𝒍 𝑩𝒐𝒏𝒅 𝑷𝒓𝒐𝒄𝒆𝒆𝒅𝒔∗ 𝟏𝟐𝟏𝟎
At 10%: HPR =
𝑷𝟎
−𝟏= 𝟏𝟎𝟎𝟎
− 𝟏 = 𝟐𝟏. 𝟎%
𝑻𝒐𝒕𝒂𝒍 𝑩𝒐𝒏𝒅 𝑷𝒓𝒐𝒄𝒆𝒆𝒅𝒔∗ 𝟏𝟐𝟎𝟖
At 8%: HPR = −𝟏= − 𝟏 = 𝟐𝟎. 𝟖%
𝑷𝟎 𝟏𝟎𝟎𝟎
* includes re-invested coupons at re-investment rate
q In the example from the previous slide the realized compound yield is:
𝟏 /𝑻 𝟏 /𝟐
At 10%: Realised Yield = 𝟏 + 𝑯𝑷𝑹 − 𝟏 = 𝟏. 𝟐𝟏 − 𝟏 = 𝟏𝟎. 𝟎%
𝟏 /𝑻 𝟏 /𝟐
At 8%: Realised Yield = 𝟏 + 𝑯𝑷𝑹 − 𝟏 = 𝟏. 𝟐𝟎𝟖 − 𝟏 = 𝟗. 𝟗𝟏%
BKM 14.3
23
Realised Compound Yield
q In summary, the steps to derive the realised compound yield are:
① Reinvest all interim cash flows to the end of holding period (at the
market interest rates available at different horizons)
② Calculate the aggregate cash flow (Total Bond Proceeds) to the end of
the holding period
③ Calculate HPR : divide Total Bond Proceeds by the original price P0
④ Annualise the return: Realised Yield = 1 + 𝐻𝑃𝑅 1/𝑇 − 1, where T is the
holding period in years
q Realised compound yield could be calculated for any holding period
q Note that:
Realised compound yield < YTM if interest rates fall
Realised compound yield > YTM if interest rates rise
Realised compound yield = YTM if interest rates remain constant
BKM 14.3
24
Realised Compound Yield: Example 2
q Assume the following bond parameters
0 1 2
Ø FV: $100 face value
Bond
Ø T: 2 years of time to maturity 96.62 10 10
100
Ø C: $10 annual coupons
Ø YTM: 12% yield to maturity (calculate and derive price of $96.62)
q Suppose we can reinvest the year 1 coupon at 10%
Calculation
Ø The Total Bond Proceeds (aggregate cash flow) at T (note: T=2) is:
CF2 = 100 + 10 + 10(1+0.1) = 121
Ø The 2-year HPR = 121/96.62 - 1 = 0.25 (25%)
Ø The realized compound yield = (1.25)1/2 – 1 ≈ 11.9%
BKM 14.3
25
Term Structure: the Yield Curve
q The term structure of interest rates essentially refers to how interest rates
vary over different investment horizons
q The term structure of interest rates is often referred to as the Yield Curve
Ø The yield curve displays the relationship between yield and maturity
Ø The yield curve can imply market expectations on future interest rates
q Interest rates can be thought

of as the price of future cash
flows. When these prices
change, the yield curve shifts
q As seen in the graph, the yield
curve is typically upward
sloping but can also be flat or
downward sloping (“inverted”)
BKM 15.1
26
Zero Coupon Bonds
q If the coupon rate is zero, the entire return comes from price appreciation ie
all return is capital gain
q Zero coupon bonds avoid reinvestment risk (no coupons to re-invest)
q Zeros trade at a deep discount to par as all return is back-ended
q A coupon bond can be viewed as a portfolio of zeros
Ø Each coupon can be considered a maturing zero-coupon bond of the
same term
q Bond stripping is the process of spinning off each coupon and principal
payment as a separate zero
q Technically, the yield curve should be derived from the market interest rate
on a series of zeros – this is known as the pure yield curve. However, this
is not always possible
BKM 15.1
27
Types of Yield Curves
Pure Yield Curve On-the-run Yield Curve
q The pure yield curve uses q The on-the-run yield curve uses
stripped or zero-coupon bonds recently issued coupon bonds
selling at or near par
q The pure yield curve may differ
significantly from the on-the-run q On-the-run bonds have the
yield curve greatest liquidity in the market
q In reality it may be difficult to q The financial press typically
derive the pure yield curve, as publishes on-the-run yield
relevant zeros may not be curves
available in the market
BKM 15.1
28
Spot Rate
q The pure yield curve is derived from the yields on zero-coupon bonds of
differing maturities
q These zero-coupon yields are known as the spot rate (yt)
q The spot rate is the interest rate today (ie at time 0) for a t-period zero
coupon bond (ie starting today and ending at time t)
q Conceptually, the spot rate (yt) can differ from the YTM (y) of a t-period
bond because the YTM applies to any type of bond whereas the spot rate
specifically refers to zero-coupon bonds
Ø For zero-coupon bonds, these two values are the same
Ø Spot rate is sometimes informally called the “pure yield”
BKM 15.1
29
Inferring the Term Structure from Zeros
q We have a 1-year zero coupon bond and a 2-year zero coupon bond as
follows: y 1
y 1
Bond A A
-PA FVA y2 -90.91 100 y2
Bond B B
-PB FV B -79.72 0 100
q The price of a t-year zero coupon bond is given by:

1
FV æ FV ö t
P= Û yt = ç ÷ -1
(1 + yt )
t
è P ø
q Therefore:
100 100
PA = 90.91 = Û y1 = - 1 » 10%
(1 + y1) 90.91
100 100
PB = 79.72 = Û y2 = - 1 » 12%
(1 + y2 )
2
79.72
BKM 15.1
30
Example 2: Zero + Coupon Bond
q Now consider a 1-year zero coupon bond and a 2-year coupon bond:
y1
Bond A
-PA FVA
y2
Bond B
-PB c C+FV B
q How do we derive the 1-year and 2-year spot rates – y1 and y2?
Ø y1 can be inferred from bond A’s price as shown on the previous slide
Ø Bond B’s pricing equation is given by:
!! (&'# !")
P = ! + "
"#$! "#$"
Ø So we can easily calculate 𝑦2 based on Bond B’s price given y1

BKM 15.1
31
Example 2: Zero + Coupon Bond (cont)
q Consider the following 1-year zero coupon bond and 2-year coupon bond:
y1
Bond A
-90.91 100
y2
Bond B
-95.78 10 110
q We derive y1 and y2 (and thus the term structure) as follows:

Ø y1 = 10% as shown in the previous example
Ø y2 is derived as:
"# ""#
𝑃! = 95.78 = + → 𝑦) ≅ 12.65%
("%"#%) ("%(! )!
BKM 15.1
32
Generalised Method
q For a 1-period zero and a 2-period coupon bond the generalised steps are:
① Find y1 from the price equation of the 1-period zero coupon bond
② Substitute y1 into the price equation for the 2-period coupon bond, and
find y2
q We can repeat this for any number of periods to find the spot rate for any t,
by substituting y1, y2, …, yt-1 into the price equation of any t-period coupon
bond (this iterative method is called bootstrapping)
BKM 15.1
33
Inferring from Coupon Bonds Only
q Now consider two 2-year coupon paying bonds:
Bond A
-PA CA CA+FVA
Bond B
-PB CB CB+FVB
q How do we derive the 1-year and 2-year spot rates – y1 and y2?
Ø We have two price equations here (for Bonds A and B). Solve the two
equations for two unknowns y1 and y2 simultaneously
q Similarly, if we are pricing any t-period coupon bond (with maturity equal or
less than t), we can solve those equations to find y1, y2, … up to yt
Ø Unlikely anything above a 2-equation system will be asked in an exam
BKM 15.1
34
Next Lecture
q Future Interest Rates and Duration
Key Concepts
Ø Bond Arbitrage
Ø Future interest rates – short rates and forward rates
Ø Term structure hypotheses
Ø Interest rate risk
Ø Duration, convexity and immunization
Readings
Ø BKM 15 Term Structure of Interest Rates: 15.2 – 15.4
Ø BKM 16 Managing Bond Portfolios: 16.1 – 16.3
35

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UNSW Business School/ Banking & Finance

q Yield / return measures

q Introduction to the term structure of interest rates

q Essentially a borrowing-lending contract where the issuer makes interest

q What would we do?

q The bond is just a combination of future cash flows (CFs)

q But how do we derive the appropriate discount rates yt ?

That is: Price = Coupon x Annuity Factor + FV x PV Factor

200 Par Bond:

q Therefore we have measures for the actual return on a bond:

q Interest rates can be thought

q The price of a t-year zero coupon bond is given by:

Ø So we can easily calculate 𝑦2 based on Bond B’s price given y1

q We derive y1 and y2 (and thus the term structure) as follows:

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