Coupon Bonds
Pay a stated coupon at periodic intervals prior to maturity.
Pay the bonds face value at maturity.
FloatingRate Bonds
Pay a variable coupon, reset periodically to a reference rate.
Pay the bonds face value at maturity.
T T
T T
R
B
Interest Rate Bond 1 Bond 2 Bond 3
1Year 2Year 10Year
9.990% $909.1736 $826.5966 $385.8940
9.995% $909.1322 $826.5214 $385.7186
10.000% $909.0909 $826.4463 $385.5433
10.005% $909.0496 $826.3712 $385.3681
Method 1 $0.082652 $0.150283 $0.350669
Method 2 $0.082645 $0.150263 $0.350494
Method 3 $0.082645 $0.150263 $0.350494
DV01: A Graphical Approach
DV01 estimates the change in the Price
Interest rate curve using a linear
approximation.
higher slope implies greater sensitivity
10Year
$0.00
$200.00
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
Interest Rate
Valuing Coupon Bonds
Example 1: Amortization Bonds
Consider Amortization Bond
T=2
m=2
C=$2,000 c = C/m = $2,000/2 = $1,000
R=10% i = R/m = 10%/2 = 5%
How can we value this security?
Brute force discounting
Similar to another security we already know how
to value?
Replication
0 1 2 3 4
Buy Coupon Bond $3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Buy 6Month Zero $952.38
Buy 1Year Zero $907.03
Buy 1.5Year Zero $863.84
Buy 2Year Zero $822.70
Portfolio $3,545.95
Valuing Coupon Bonds
Example 1: Amortization Bonds
Compare with a portfolio of zero coupon
bonds:
A First Look at Arbitrage
Reconsider amortization bond; suppose bond trades
at $3,500 (as opposed to computed price of
$3,545.95)
Can we make a profit without any risk?
What is the strategy?
What is the profit?
A First Look at Arbitrage
Reconsider amortization bond; suppose bond
trades at $3,500 (as opposed to computed
price of $3,545.95)
Can make risk less profit
Buy low: buy amortization bond
Sell high: Sell portfolio of zero coupon bonds
riskless profit of $45.95
no riskless profit if price is correct
0 1 2 3 4
Buy Coupon Bond $3,500.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Sell 6Month Zero $952.38 $1,000.00 $0.00 $0.00 $0.00
Sell 1Year Zero $907.03 $0.00 $1,000.00 $0.00 $0.00
Sell 1.5Year Zero $863.84 $0.00 $0.00 $1,000.00 $0.00
Sell 2Year Zero $822.70 $0.00 $0.00 $0.00 $1,000.00
Portfolio $3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Net Cash Flow $45.95 $0.00 $0.00 $0.00 $0.00
Time Period
What is the market price of a U.S. Treasury
bond that has a coupon rate of 9%, a face
value of $1,000 and matures exactly 10 years
from today if the interest rate is 10%
compounded semiannually?
0 6 12 18 24 ... 120
Months
45 45 45 45 1045
Valuation of Coupon Bonds:
Example 2: Straight Bonds
What is the market price of a bond that has an
annual coupon C, face value F and matures
exactly T years from today if the required rate
of return is R, with mperiodic compounding?
Coupon payment is: c = C/m
Effective periodic interest rate is: i = R/m
number of periods N = Tm
0 1 2 3 4 ...
N
c c c c
c+F
Valuing Coupon Bonds
The General Formula
   
( ) ( )
(
+
+
(
+
=
+ =
N N
i
F
i
i
c
Zero Annuity B
1 1
1
1
The Concept of a Yield to
Maturity
So far we have valued bonds by using a given interest rate,
then discounted all payments to the bond.
Prices are usually given from trade prices
need to infer interest rate that has been used
Definition: The yield to maturity is that interest rate that
equates the present discounted value of all future payments to
bondholders to the market price:
Algebraic:
( ) ( )
N N
m yield
F
m yield
m yield
c
B
/ 1 / 1
1
1
/
+
+


.

\

+
=
Yield to Maturity
A Graphical Interpretation
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
$2,500.00
0
%
2
%
4
%
6
%
8
%
1
0
%
1
2
%
1
4
%
1
6
%
1
8
%
2
0
%
2
2
%
2
4
%
Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of
$1,000 and matures exactly 10 years from now.
Market price of $1,500, implies a yield of 3.91% (semiannual compounding);
for B=$1,000 we obviously find R=10%.
Interest Rate Sensitivity:
Coupon Bonds
Coupon bonds can be represented as portfolios of zero
coupon bonds
Implication for price sensitivity
Consider purchasing the US Treasury bond discussed earlier
(10 year, 9% coupon, $1,000 face)
Suppose immediately thereafter interest rates fall
to 8%, compounded semiannually.
Suppose immediately thereafter interest rate rises
to 12% compounded semiannually.
Suppose the interest rate equals 9%, compounded
semiannually.
What are the pricing implications of these scenarios?
Similarly:
If R=12%: B=$ 827.95
If R= 9%: B=$1,000.00
Implication of Interest Rate
Changes on Coupon Bond Prices
( ) ( )
(
+
+
(
+
=
N N
i
F
i
i
c
B
1 1
1
1
Relationship Between Coupon
Bond Prices and Interest Rates
Bond prices are inversely related to interest rates (or yields).
A bond sells at par only if its interest rate equals the coupon
rate
A bond sells at a premium if its coupon rate is above the
interest rate.
A bond sells at a discount if its coupon rate is below the
interest rate.
DV01 and Coupon Bonds
Consider two bonds with 10% annual coupons
with maturities of 5 years and 10 years.
The APR is 8%
What are the responses to a .01% (1bp)
interest rate change?
Does the sensitivity of a coupon bond always
increase with the term to maturity?
Yield 5Year Bond $ Change % Change 10Year Bond $ Change % Change
7.995% $1,080.06 $0.21019 0.0195% $1,134.57 $0.36585 0.0323%
8.000% $1,079.85 $1,134.20
8.005% $1,079.64 $0.21013 0.0195% $1,133.84 $0.36569 0.0322%
DV01 $0.42032 $0.73154
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
$2,500.00
0
%
2
%
4
%
6
%
8
%
1
0
%
1
2
%
1
4
%
1
6
%
1
8
%
2
0
%
2
2
%
2
4
%
Interest Rate (R)
P
r
i
c
e
(
P
)
5Year Bond
10Year Bond
Bond Prices and Interest Rates
Longer term bonds are more sensitive to
changes in interest rates than shorter term bonds, in general.
Consider the following two bonds:
Both have a maturity of 5 years
Both have yield of 8%
First has 6% coupon, other has 10% coupon,
compounded annually.
Then, what are the price sensitivities of these
bonds, measured by DV01 as for zero coupon
bonds?
Why do we get different answers for two
bonds with the same yield and same maturity?
Bond Yields and Prices
Yield 6%Bond $ Change % change 10%Bond $ Change % change
7.995% $920.33 $0.1891 $1,080.06 $0.2102
8.000% $920.15 $1,079.85
8.005% $919.96 ($0.1891) $1,079.64 ($0.2101)
0.0411% 0.0389%
DV01 $0.3782 $0.4203
Maturity and Price Risk
Zero coupon bonds have welldefined relationship
between maturity and interest rate sensitivity:
Coupon bonds can have different sensitivities for the
same maturity
DV01 now depends on maturity and coupon
Need concept of average maturity of coupon bond:
Duration
Duration
Duration is a weighted
average term to maturity
where the weights are
relative size of the
contemporaneous cash
flow.
Duration is a unitless
number that quantifies the
percentage change in a
bonds price for a 1
percentage change in the
interest rate.
B
F PV
N
T
B
N
c PV
N
T
B
c PV
T
B
c PV
T Duration
) (
) ( )
2
(
2
)
1
(
1
+ + + + =

.

\

+
c

.

\

c
=
+
c
c
=
R
R
B
B
B
R
R
B
Duration
1
1
Duration (cont.)
The duration of a bond is less than its time to maturity (except
for zero coupon bonds).
The duration of the bond decreases the greater the coupon
rate. This is because more weight (present value weight) is
being given to the coupon payments.
As market interest rate increases, the duration of the bond
decreases. This is a direct result of discounting. Discounting
at a higher rate means lower weight on payments in the far
future. Hence, the weighting of the cash flows will be more
heavily placed on the early cash flows  decreasing the
duration.
Modified Duration = Duration / (1+yield)
Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD TIME
DATE CHANGE
3Month 08/16/2007 4.72 / 4.84 0.01 / .010 13:41
6Month 11/15/2007 4.78 / 4.98 0.01 / .015 13:41
Notes/Bonds
COUPON MATURITY CURRENT PRICE/YIELD TIME
DATE PRICE/YIELD CHANGE
2Year 4.500 04/30/2009 991214 / 4.84 002 / .035 14:08
3Year 4.500 05/15/2010 990812 / 4.77 00312 / .040 14:06
5Year 4.500 04/30/2012 982812 / 4.75 006 / .043 14:07
10Year 4.500 05/15/2017 9715 / 4.82 00912 / .038 14:07
30Year 4.750 02/15/2037 9617+ / 4.97 017 / .035 14:07
A Few Bond Markets Statistics
U.S. Treasuries, May 20th 2007.
Spot Rates
A spot rate is a rate agreed upon today, for a loan that is to
be made today
r
1
=5% indicates that the current rate for a one
year loan is 5%.
r
2
=6% indicates that the current rate for a two
year loan is 6%.
Etc.
The term structure of interest rates is the series of spot
rates r
1
,
r
2
,
r
3
,
We can build using STRIPS or coupon bond
yields.
Explanations of the term structure.
The Term Structure of Interest
Rates
An Example
1 2 3
Yield
Maturity
5.00
5.75
6.00
Term Structure, July 1
st
2005.
Term Structure, September 12
th
,
2006
Term Structure, May 20
th
, 2007
Term Structure of Interest Rates
Summary
Bonds can be valued by discounting their future cash
flows
Bond prices change inversely with yield
Price response of bond to interest rates depends on
term to maturity.
Works well for zerocoupon bond, but not for coupon
bonds
Measure interest rate sensitivity using DV01 and
duration.
The term structure implies terms for future
borrowing:
Forward rates
Compare with expected future spot rates
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