Professional Documents
Culture Documents
Spring 2023
Da-Hea Kim
Overview
Measuring interest rates
Bond
Yields
Market price quotes
Default risk
Actual amount of interest implied in a stated interest rate depends on the following:
The number of times the interest is earned per year Annually (m=1) R
𝑹 𝟏
R% per annum, frequency=m ⇔ % per year Semiannually (m=2) R/2
𝒎 𝒎
Compound
The value of $100 in one year
100
=
0 0.5 1
=
100
0 0.5 1
Compound
The value of $100 in one year
=
100
0 0.5 1
Simple Compound
Frequency
interest rate interest rate
? R per annum
$1
Simple Compound
Frequency
interest rate interest rate
Sometimes rates of return are given for a period shorter than a year
o APR
• Rate that annualizes per-period rates using a simple interest approach, ignoring compound interest
• APR=_______________
o EAR
• Rate at which money actually grows over a year
• Compound rate with annual compounding frequency
• EAR=____________________
An interest rate on a credit card loan is 1.5 percent month, with the interest compounded monthly.
The borrower issues (i.e., sells) a bond to the lender for some amount of cash.
Bond
Issuer Holder
= Borrower =Lender
$X
The arrangement obligates the issuer to make specified payments to the bondholder on
specified dates.
Specification
• Cash flows
0 1 2
Coupon bond
• Face value: $100, Coupon rate: 6% per annum (m=2), Maturity: 2 years
• Cash flows
0 1 2
Zero-coupon bond
• Face value: $100, Maturity: 2 years
• Cash flows
0 1 2
Perpetuity bond
• Face value: $100, Coupon rate: 6% per annum (m=2)
• Cash flows
0 1 2 3
A company issues two kinds of bonds with the identical conditions except for a
coupon rate.
The sum of present values of all the expected cash flows from the bond
Discounted cash flows with the appropriate required rate of returns, reflecting the riskiness.
There may be different discount rates for cash flows accruing in different periods.
C
C C C F
0 t1 t2 … tn
𝑷𝑽(𝑪)
Discounted by 𝑟
𝑷𝑽(𝑪)
Discounted by 𝑟
…
+) 𝑷𝑽(𝑪 + 𝑭)
Discounted by 𝑟
Bond price
Interest Rate
0 0.5 1 1.5 2 Maturity
(% per annum,
(years)
semi-annual compounding)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
Interest Rate
0 0.5 1 1.5 2 Maturity
(% per annum,
(years)
semi-annual compounding)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
Example1) A $1,000 face value bond paying semiannual coupons of $40 has a price of $1,032.25.
o Coupon rate:
o Current yield:
Example2) A $1,000 face value bond paying semiannual coupons of $40 has a price of $969.75.
o Coupon rate:
o Current yield:
Ex) Zero-coupon bond, Face value: $100, Maturity: 2 years, Bond price: $95
0 0.5 1 1.5 2
Try y 𝐁(𝒚)
1
2
3
4
…
C+F
C C C
0 ∆t 𝟐∆t … (𝐧 − 𝟏)∆t n∆t=T
B=
𝟏 𝒓𝒏
𝟏 𝒓
𝑪 𝟏
where 𝒚𝒎 ∆𝒕×𝒎 𝒚𝒎 ∆𝒕×𝒎
𝟏 𝟏
𝒎 𝒎
C+F
C C C C 𝟏 𝟏 𝑭
𝑩= 𝑪× ∆𝒕×𝒎
𝟏− 𝑻×𝒎
+ 𝒎×𝑻
0 ∆t 𝟐∆t 3∆t … (𝐧 − 𝟏)∆t n∆t 𝒚 𝒚 𝒚
𝟏+ −𝟏 𝟏+ 𝟏+
=T 𝒎 𝒎 𝒎
Example)
Annual coupon payments with a YTM with an annual compounding frequency
C+F ∆𝒕 =
C C C C ⇒𝑩=
T
𝒎=
0 𝟏 𝟐 3 … (𝐓 − 𝟏)
C+F ∆𝒕 =
C C C C ⇒𝑩=
T
𝒎=
0 𝟎. 𝟓 𝟏 1.5 … (𝐓 − 𝟎. 𝟓)
Relation b/w
Price of an 8% coupon bond
Types of a bond
with a face value of $1,000
Premium bond
(bond price > face value)
Par bond
(bond price = face value)
Discount bond
(bond price < face value)
8%
Yield-to-maturity
The YTM is a standard measure of the total rate of return on the bond.
Example) Par bond with coupon rate: 10% per annum (m=1), Maturity: 2 years
• 1-year reinvestment rate at the end of the year=10% per annum (m=1)
• What is the realized compound return (m=1) at the maturity?
Example) Par bond with coupon rate: 10% per annum (m=1), Maturity: 2 years
• 1-year reinvestment rate at the end of the year=8% per annum (m=1)
• What is the realized compound return (m=1) at the maturity?
Asked
Maturity Coupon Bid Asked Change
Yield (%)
9/30/2019 1.75 99.742 99.758 -0.008 2.463
… … … … … …
8/15/2020 11 107.680 107.695 -0.125 2.303
When you buy the bond expiring Aug. 15, 2020, which quote applies?
The bond prices quoted in the financial page ≠ The prices investors pay for the bond.
• Market convention of quoting prices excluding accrued interest.
Cash price
• The price you actually pay
• Full or invoice price
• Dirty price
Accrued interest
• The prorated share of the upcoming coupon
• When a bond pays its coupon, accrued interest reverts to zero.
Cash price:_______________________________________
Prediction for
bond safety
-4
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
▲ Yield spreads between corporate and 10-year Treasury bonds
(Aaa-rated, Baa-rated, Junk bonds)
𝟏𝟎𝟎 𝟏/𝟑
𝑹= − 𝟏 = 𝟏𝟎%
𝟕𝟓.𝟏𝟑
5.0
4.0
3.0
2.0
1.0
0.0
0 0.5 1 1.5 2 2.5
Years
Yield
Yield
Maturity Maturity Maturity
Expectation theory
T1 R1
0 T1 T2
T2 R2 F12
𝑹𝟐
4 5.0
Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒 in each year
𝑹𝟏 = 𝟑%
𝑹𝟐 = 𝟒%
𝑹𝟑 = 𝟒. 𝟔%
𝑹𝟒 = 𝟓%
Long-term interest rates should reflect expected future short-term interest rates.
Upward sloping yield curve implies that interest rates will increase in the future.
Empirical observation
Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒
• Upward sloping yield curve in each year
Lenders prefer to preserve their liquidity and lend funds for short period of time.
Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒 in each year
𝟏 , 𝟐 , 𝟑 , 𝟒
What are the following forward rates, 𝟏,𝟏 𝟏,𝟐 and 𝟏,𝟑 , where 𝟏,𝒌 refers to a forward
rate for the period beginning in one year and extending for k years?
(Assume that all interest rates are expressed with an annual compounding frequency.)