We have expressed the price of an optionfree
bond as a function of the bond’s yield to
maturity:
P =
c
2
1+
y
2
( )
i÷1+q
i=1
n
¿
+
1
1+
y
2
( )
n÷1+q
where q =
days from settlement to next coupon date
days in current coupon period
Bond Yield to Maturity
Different bonds have different yields
Risk differentials (quality spread)
Sector spreads (e.g. industrials v. utilities)
Optionality
Tax differences
Term differences
Benchmark: Treasuries
Risky bonds priced at a spread to Treasuries
Yield Curve
A graph of bond yields to maturity by time to
maturity is called a yield curve.
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
Typically, the yield curve is upward sloping
Yield to maturity rises with term to maturity
The excess of the long yield over the short yield is called a
“term premium”
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
Other shapes are also possible, however
Inverted: Commonly associated with recessions
Flat
1.00%
1.00%
3.00%
5.00%
7.00%
9.00%
11.00%
13.00%
15.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
It used to be that most fixed income securities
were priced at a spread relative to the Treasury
yield curve.
For example:
If the yield to maturity on the 10year Treasury
bond was 7%, then a 10year Baa corporate bond
would be priced to yield 7% plus the Baa credit
spread.
The problem with this approach is that it ignores
differences in duration and convexity that may be
priced. Can you see why?
Yield Curve
Here’s yield curve data for ontherun
Treasuries of various maturities:
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
7.38% 1 5.49% $101.81
9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
6.75% 2 1/2 5.86% $102.03
7.75% 3 5.93% $104.94
6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
Notice the
range of
coupons.
These bonds
have very
different cash
flow patterns.
A Better Approach
To avoid the problems of comparability caused
by differing cash flow patterns among onthe
run Treasuries, we can realize that each coupon
bond is really a package of single payment
bonds.
For example, a 2year 10% coupon bond is
really a package of five single payment bonds:
four for the semiannual coupon payments and
one for the repayment of the corpus.
Zeroes
A single payment bond is called a “zero.”
A coupon bond can be thought of as a package
of zeroes,
one for each of the coupon payments and
one for the corpus.
In principle, any coupon bond could be
“stripped” or “unbundled” into its constituent
zeroes.
US Treasury STRIPS are unbundled coupon bonds.
Spot Yields
A “spot yield” is the current yield to maturity
on a zero coupon bond.
For example, the 1year spot yield is the yield to
maturity on a 1year zero.
The price (per dollar of corpus) of an nyear
zero is related to the nyear spot rate by the
formula:
0
P
n
=
1
1+
i
n
2

\

.
2n
Spot Yields
For example, if the 3 1/2 year spot yield is
6.05%, then the price (per dollar of corpus) of
the 3 1/2 year zero is:
0
P
3.5
=
1
1+
.0605
2
( )
2*3.5
=
1
1.03025
( )
7
= .811
Spot Yields
Alternatively, we can express the nyear spot
yield as a function of the price of an nyear
zero:
i
n
= 2
1
0
P
n

\

.

1
2n
÷1

\

.


Spot Yields
For example, if a 4 year zero is priced at $.79
per dollar of face value, then the 4year spot
rate is:
i
4
= 2
1
0
P
4

\

.

1
2*4
÷1

\

.


= 2
1
.79

\

.
1
8
÷1

\

.

= 2 1.03059 ÷1 ( ) = 6.12%
Spot Yields
Term (yrs) Spot Yield Price of zero
1/2 5.10% $0.98
1 5.49% $0.95
1 1/2 5.64% $0.92
2 5.82% $0.89
2 1/2 5.88% $0.87
3 5.95% $0.84
3 1/2 6.05% $0.81
4 6.12% $0.79
4 1/2 6.12% $0.76
5 6.19% $0.74
0
P
2.5
=
1
1+
.0588
2

\

.
5
= .87
i
4.5
= 2
1
.76

\

.
1
9
÷1

\

.

= 6.12%
Price of a Coupon Bond
In principle, the price of an nyear coupon
bond ought to be equal to the total value of all
its constituent zeroes:
P =
c
2
1+
y
2

\

.
s
s=1
2n
¿
+
1
1+
y
2

\

.
2n
=
c
2
1+
i
s
2
2

\

.

s
s=1
2n
¿
+
1
1+
i
n
2

\

.
2n
Priced using yield to maturity Priced using spot yields
Price of a Coupon Bond
For example:
This bond actually traded at a price of $1.0569 or a yield
to maturity of 6.16%
n Spot Yield Price of zero Cash flow Value
1/2 5.10% $0.98 $0.0375 $0.0366
1 5.49% $0.95 $0.0375 $0.0355
1 1/2 5.64% $0.92 $0.0375 $0.0345
2 5.82% $0.89 $0.0375 $0.0334
2 1/2 5.88% $0.87 $0.0375 $0.0324
3 5.95% $0.84 $0.0375 $0.0315
3 1/2 6.05% $0.81 $0.0375 $0.0304
4 6.12% $0.79 $0.0375 $0.0295
4 1/2 6.12% $0.76 $0.0375 $0.0286
5 6.19% $0.74 $1.0375 $0.7647
$1.0571
5year 7.5% coupon bond
STRIPS
Go to spreadsheet for comparison of stripping
and reconstituting 2 different 10yr bonds.
Term Structure
The term structure of interest rates is the
pattern of spot rates over the range of
maturities.
A flat term structure means that spot yields are
equal at all maturities.
A normal term structure slopes upward
An inverted term structure slopes downward
Modern pricing practice is to regard any bond
as a package of zeros and price the package
using spreads relative to the term structure.
Bootstrapping
We can derive the theoretical term structure
from the yield curve using a procedure known
as “bootstrapping.”
Here’s yield curve information
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
7.38% 1 5.49% $101.81
9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
6.75% 2 1/2 5.86% $102.03
7.75% 3 5.93% $104.94
6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
Bootstrapping
The first bond has 1/2 year to run
It is a single payment bond that will pay
$1.0425 per dollar of face value at maturity.
Its price is $1.0166 per dollar of face value.
Therefore the 1/2 year spot rate is
i
1/ 2
= 2
1.0425
1.0166

\

.
1
÷1

\

.

= 2 .0255 ( ) = 5.10%
Bootstrapping
Given the 1/2 year spot rate, we can determine
the price of the 1/2 year zero:
0
P
1/ 2
=
1
1+
i
1/ 2
2

\

.
2 1/ 2
( )
=
1
1+
.0510
2

\

.
= .9751
Bootstrapping
For each dollar of face value, the 1year bond
will pay $.03675 in 6 months and $1.03675 in
one year.
It’s price ($1.0181 per dollar of face value)
should equal
$1.0181 =
$0.03675
1+
i
1/ 2
2

\

.
1
+
$1.03675
1+
i
1
2

\

.
2
Bootstrapping
But since the 6months spot rate is 5.10%,
$1.0181 =
$0.03675
1+
.0510
2

\

.
1
+
$1.03675
1+
i
1
2

\

.
2
Which we can solve for the 1year spot rate as
i
1
= 2
1.03675
1.0181÷ .03596

\

.
1/ 2
÷1

\

.

= 5.49%
Bootstrapping
Or, we could write
$1.0181 =
$0.03675
1+
i
1/ 2
2

\

.
1
+
$1.03675
1+
i
1
2

\

.
2
as
$1.0181= $0.03675*
0
P
1/ 2
+ $1.03675*
0
P
1
= $0.3675 .9751 ( )+ $1.03675*
0
P
1
= $0.03596+ $1.03675*
0
P
1
solve for
0
P
1
and then i
1
Bootstrapping
You continue this process to complete the
theoretical term structure
Coupon Maturity Yield Price Zero Price Spot Yield
8.50% 0.5 5.10% $101.66 $97.51 5.10%
7.38% 1 5.49% $101.81 $94.73 5.49%
9.00% 1.5 5.63% $104.78 $92.00 5.64%
8.88% 2 5.81% $105.72 $89.16 5.82%
6.75% 2.5 5.86% $102.03 $86.51 5.88%
7.75% 3 5.93% $104.94 $83.88 5.95%
6.25% 3.5 6.03% $100.69 $81.16 6.05%
5.63% 4 6.09% $98.38 $78.58 6.12%
6.50% 4.5 6.10% $101.56 $76.23 6.12%
7.50% 5 6.16% $105.69 $73.71 6.19%
Forward Rates
A forward rate of interest is a yield quoted now
on a zero coupon bond to be delivered in the
future.
For example, a 2year rate 1year forward is
the yield quoted today on a 2year zero starting
one year from now and maturing 3 years from
now.
0 1 2 3
Forward Rates
Forward rates are embedded in the term
structure.
Suppose you own a zero that matures in 1 year
and yields 6%.
Interest could accumulate at the same rate over the
entire year or
It could accumulate at one rate for the first half year
and at another rate for the second half year such that
the average is 6%.
Forward Rates
0 1/2
1
Forward Rates
Algebraically, if you invest
0
P
1
at 6% for 1
year, and interest accumulates at the same rate
throughout the year, then at the end of a half
year you will have
0
P
1
1+
.06
2

\

.
And at the end of a
year you will have
0
P
1
1+
.06
2

\

.
2
Forward Rates
Alternatively, if you invest
0
P
1
at say 4% for
1/2 year, and then reinvest the proceeds at
another rate, say
1
r
1
, then at the end of a half
year you will have
0
P
1
1+
.04
2

\

.
And at the end of a
year you will have
0
P
1
1+
.04
2

\

.
1+
1
r
1
2

\

.
Forward Rates
These two accumulation paths will both result
in a 6% yield for the year if
1+
.06
2

\

.
2
= 1+
.04
2

\

.
1+
1
r
1
2

\

.
That is, if
1
r
1
= 2
1+
.06
2
( )
2
1+
.04
2
( )

\

.

÷1

\

.

Forward Rates
Generally
s
r
1
2
= 2
0
P
s
0
P
s+
1
2

\

.

÷1

\

.
