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Pricing Fixed Income Securities

DISCOUNT FACTORS
The discount factor between two dates, t and T, provides the
term of exchange between a given amount of money at t versus
a (certain) amount of money at a later date T:
The discount factor is denoted by Z(t,T)
If the Treasury issued 182-day Treasury bills at a price of Rs.97.477 for
Rs.100 of face value , it implies That is, market participants were willing
to exchange 0.97477 rupees on the first date for 1 rupee six months
later
This Treasury bill would not make any other payment between the two
dates
The ratio between purchase price and the payoff, 0.97477 =
Rs.97.477/Rs.100, can be considered the market-wide discount factor
for 6 months

DISCOUNT FACTORS
The notion of discount factor is unambiguous
while that of interest rate is not as it depends on
the compounding frequency.
Discount rates are at the heart of fixed income
securities analysis as they unambiguously
represent an exchange rate between money
today versus money tomorrow.

Discount Factors across


Maturities
Z( t, T) records the time value of money between
t and T
At any given time t, the discount factor depends
on its maturity T.
It is lower, the longer the maturity T.
That is given two dates T1 and T2, with T1 < T2, it
is always the case that
Z(t,T1) Z(t,T2)

It is always the case that market participants


prefer a money inflow sooner than later

Discount Factors across Time


Discount factors give the current value (price) of
receiving Re.1 at some point in the future
These values are not constant over time
One of the variables that determines this value is
inflation:
Higher expected inflation, makes less appealing
money in the future so discounts go down
Inflation is not the only variable that explains discount
factors

Discount Factors, Interest Rates,


and Compounding Frequencies
Interest rates are closely related to discount
factors and are more similar to the concept of
return on an investment
Yet these are more complicated, because they
depend on the compounding frequency
The compounding frequency of interest
accruals refers to the number of times within a
year in which interests are paid on the invested
capital
For a given interest rate, a higher compounding
frequency results in a higher payoff
For a given payoff, a higher compounding
frequency results in a lower interest rate

Discount Factors, Interest Rates,


and Compounding Frequencies
Discount factors and interest rates are intimately
related once we make explicit the compounding
frequency.
Given an interest rate and its compounding
frequency, we can define the discount factor.
Similarly , given a discount factor, we can define
an interest rate together with its compounding
frequency.

Compounding Frequencies
Two compounding frequencies are important:
semi-annual and continuous.
Semi-annual compounding
payment on treasuries.

matches

coupon

Continuous compounding is important for its


analytical convenience.
Formulas and derivations are much simpler under
the assumption of continuous compounding.

Discount Factor
We can derive the discount rate from the semiannually compounded interest rate.
Let r2 (t, T) denote the (annualized) semi-annually
compounded interest rate between t and T. The
2(T t )
payoff at T would be:
r2 (t , T )

Investment
at
t

Payoff at T =

Discount Factor = Investment at t / Payoff at T


Z(t, T) =

1
r2 (t , T )

2(T t )

Discount Factor
If the semi-annually compounded rate is 5%,the
corresponding discount rate is:

1
0.05
1

2*1

= 0.95181

Semi-annual Compounding
We can also obtain the semi-annual compounding rate from the discount rate

r2 t , T 2

Z t,T

1
2 T t

where Z(t,T) is a discount factor

For a one year discount rate of 0.95181, the semi-annually compounded interest
rate is
= 2*[{(1/(0.95181)0.5} 1]
= 0.05 or 5%

For FFF

More Frequent Compounding


Let the discount factor Z(t,T) be given, and let
rn(t,T)
denote
the
annualized
n-times
compounded interest rate. Then rn(t,T) is defined

by the equation
1

rn t , T n

Z t, T

1
n T t

Rearranging for Z(t,T), we obtain


Z t,T

rn t , T

n T t

Continuous Compounding
The continuously compounded interest
rate is obtained by increasing the
compounding frequency
to
r t ,T n
T
t infinity
Z t,T e

Solving for r(t, T) we obtain:


r t,T

ln Z t , T

T t

where ln(.) denotes the natural logarithm

Continuous Compounding

The Relation between Interest Rates


The relationship between a given interest rate rn
(t,T) with n compounding frequency and
continuously compounded interest rate r(t,T) is
given by:

rn t , T
r t , T n ln 1

rn t , T n e

r t ,T
n

The Term Structure of Interest Rates


The term structure of interest rates, or spot
curve, or yield curve, at a certain time t defines
the relation between the level of interest rates and
their time to maturity T
The term spread is the difference between long
term interest rates (e.g. 10 year rate) and the short
term interest rates (e.g. 3 month interest rate)
The term spread depends on many variables:
expected future inflation, expected growth of the
economy, agents attitude towards risk, etc.
The term structure varies over time, and may take
different shapes

The Shapes of the Term


Structure

The Term Structure of Interest Rates


Over Time

Price of Zero Coupon Bonds


The price of zero coupon bonds (with a
principal value of Rs.100) issued by the
government is equal to:
Pz t , T 100 Z t , T
The subscript z is mnemonic of Zero
coupon bond
This means that from observed prices for
zero coupon bonds we can compute the
discount factors

Price of a Coupon Bond


A coupon bond can be represented
by a sequence of its cash payments.
If we know the discount factors Z( t,
T) to apply to these cash payments,
we can compute the value of a
coupon bond.

From Zero Coupon Bonds to


Coupon Bonds
Consider a coupon bond at time t with coupon
rate c, maturity T and payment dates T1,T2,,Tn =
T.
Let there be discount factors Z(t, Ti) for each date
Ti. Then thec value
the coupon bond can be
n
100 of
Pc t , Tn as:

Z t , Ti 100 Z t , Tn
computed
2
i 1
Pc t , Tn

also:

n
c
Pz t , Ti Pz t , Tn
2 i 1

From Zero Coupon Bonds to Coupon


Bonds
An example:
A 2-year coupon coupon bond pays half-yearly coupon of
Rs.2.1875
On the date of issue, the 6-month, 1-year, 1.5-years, and 2year discounts were Z(t,t+0.5) = 0.97862, Z(t,t+1) =
0.95718, Z(t,t+1.5) = 0.936826 and Z(t,t+2) = 0.91707
Therefore, the price of the bond on that date was
4

Pc t , Tn Rs.2.1875 Z t , t 0.5 i Rs.100 Z (t , t 2)


i 1

= Rs. 2.1875*3.7897 + Rs.100*0.91707


= Rs. 99.997

Price of a Coupon Bond


We can also represent the value of a coupon bond
using semi-annual interest rate r2 (t, T)

n
c / 2 100
100
Pc (t , Tn )

2(Ti t )
(1 r2 (t , Tn ) / 2) 2(Tn t )
i 1 (1 r2 (t , Ti ) / 2)

When the semi-annual discount rate is constant


and equal to the semi-annual coupon rate, the
bond will trade at par

A No Arbitrage Argument
In well functioning markets in which both the coupon
bond Pc(t,Tn) and the zero coupon bond Pz(t,Tn) are
traded , if

c n
Pc t , Tn Pz t , Ti Pz t , Tn
2 i 1
then the arbitrageur can buy the bond for Pc(t,Tn)
and sell immediately c/2 units of zero coupon bond
with maturities T1,T2,,Tn-1 and (c/2+1) of the zero
coupon with maturity Tn
This strategy leads instantly to a profit. In a wellfunctioning market, such arbitrage opportunities
cannot last for long.

From Coupon Bonds to Zero Coupon


Bonds
With enough coupon bonds we can
compute the implicit value of zero
coupon bonds using the following
equation:
Pc t , Tn

n
c 100

Z t , Ti 100 Z t , Tn
2
i 1

Example
On t = June 30, 2005, the 6-month Treasury bill,
expiring on T1 = December 29, 2005, was trading at
Rs.98.3607
On the same date, the 1-year to maturity, 2.75%
Treasury note, was trading at Rs.99.2343
The maturity of the latter Treasury note is T2 = June
30, 2006
We can write the value of the two securities as:

Pbill(t,T1) = Rs.98.3607 =Rs.100 Z(t,T1)


Pnote(t,T2) = Rs.99.2343 = Rs1.375 Z(t,T1) +
Rs.101.375 Z(t,T2)
We
Rs.99.2343
Rs.1.375
Z t , T1 Rs
have two
equations
in.99.2343
two unknowns:
Rs.1.375 0.983607
Z t , T2

0.965542
Rs
.101.375
Rs
.101.375
Z(t,T1) = Rs.98.3607 / Rs.100 = 0.983607
.

From Coupon Bonds to Zero Coupon


Bonds
On the same date, t = June 30, 2005, the
December 31, 2006 Treasury note, with coupon
of 3%, was trading at Rs.99.1093
Denoting by T3 = December 31, 2006, the price
of this note can be written as:
P(t,T3) = Rs.1.5 Z(t,T1) + Rs.1.5 Z(t,T2) +
Rs.101.5 Z(t,T3) = Rs
Rs.99.1093
.99.1093 Rs.1.5[ Z (t , T1 ) Z (t , T2 )]
Z (t ,T3 )
Rs.101.5
Rs.99.1093 Rs.1.5(0.983607 0.965542)

Rs.101.5

= 0.947641

Bootstrap Methodology
With sufficient data we can obtain the discount factors for
every maturity This methodology is called bootstrap
methodology
Let t be a given date. Let there be n coupon bonds, with
coupon ci and maturities Ti. Assume that maturities are
regular intervals of six months. Then, the bootstrap
methodology to estimate discount factors, for every i = 1,
,n is as follows:

1. The first discount factor Z(t,T


Pc t ,1T)1 is given by:
Z t , T1

100 1 c1 / 2

2. Any other discount factor Z(t,Ti) for i =


i 1 2,,n is given by:
Pc t , Ti ci / 2 100 j 1 Z t , T j
Z t , Ti
100 1 ci / 2
.

Quoting Conventions -Treasury


Bills
Treasury bills are quoted on a discount basis;
rather than quoting a price, Treasury dealers
quote the following:
100 Pbill t , T
360
d

100

where n is the number of


days between t
n
calendar

P 100 1
d
360
and T

For example, Treasury dealers will quote the price


100 97.477 360
of a 182-day
d

4.99%
182
bill issued at a price of100
Rs.97.477
for Rs.100 of face
value as:

Yield on Treasury Bills


Bond Equivalent Yield on Treasury Bills:
BEY

100 P 365

P
n

Continuously Compounded Return on Treasury


Bills:
rt
P 100 e
P
e rt
100
P

rt ln

100
r

ln
t

100

Quoting Conventions - Treasury


Coupon Notes and Bonds
In the case of Treasury notes and bonds ,
interest accrues on the bond, if a bond is purchased
between the coupon dates,
It is market convention to quote these without any
inclusion of accrued interests, so:
Invoice (Dirty) Price = Quoted (Clean) Price + Accrued
Interest
Accrued Interest is given by:
Accrued Interest = Interest Due in Full Period
Number of Days Since Last Coupon Date/
Number of Days between Coupon Payments

The Pricing of Floating Rate Bonds


A semi-annual Floating Rate Bond with maturity
T is a bond whose coupon payments at dates t =
0.5, 1, ., T are determined by the formula:

c t 100 r2 t 0.5 s

where r2(t) is the 6-month Treasury rate at t, and s


is a spread
Each coupon date is also called reset date as it is
the time when the new coupon is reset
If the spread of a floating rate bond is equal to
zero, the ex-coupon price of a floating rate bond on
any coupon date is equal to the bond par value

The Pricing of Floating Rate Bonds


Consider a one year, semi-annual floating rate bond, with zero
spread:

The coupon at t = 0.5 depends on todays interest rate r2(0) ,


which is known. If today, r2(0) = 2%, then: c(0.5) = 100 2% / 2 =
1
Also c(1) depends on the interest rate in six months r2(0.5) which is
unknown today, yet this doesn't matter since the cash flow at that
time will be (100 + c(1)), which means that the present value will
be:

100 100 r2 0.5 / 2 100 1 r2 0.5 / 2


V 0.5

100
1 r2 0.5 / 2
1 r2 0.5 / 2

Independently of the level of interest rate r2(1) , the value of the


bond at t=0.5 is 100 . Because 100
the
coupon
at time t=0.5 is known,
1
V 0
100
the value at t = 0 is:
1 2% / 2
.

The Pricing of Floating Rate Bonds


When the spread (s) is not zero
Effectively the spread is a fixed payment on the bond
so we can
value it separately:
n

s Z 0, t
t 0.5 +
Price with spread = Price of no spread bond

At reset dates the price of the floating rate bond with


zero
spread is just par (=100),n so that
s Z 0, t
t 0.5
Price with spread = 100+

The Pricing of Floating Rate Bonds


How do we value a floating rate bond
outside of reset dates?
When the time 0 of the valuation is not a reset date:
We know that the bond will be worth
100(1+c(ti)/2) at the next reset date, note that
c(ti) is known
All we need to do is to apply the appropriate
discount to bring the value to t=0

The Pricing of Floating Rate


Bonds
If reset date is t=0.25 and not t=0
We know the cum-coupon price at time t=0.25
We have to discount this cum-coupon back to t=0
at the current 3-month rate.
If the cum-coupon price at t=0.25 is Rs.101 and
the quarterly compounded 3-month rate is 2%,
then
Rs.101
Rs.100.50
(1 0.02 / 4)

Value of bond at 0 =

The Pricing of Floating Rate Bonds


Let T1,T2,,Tn be the floating rate reset dates and
let the current date t be between time Ti and Ti+1: Ti
< t < Ti+1. The general formula for a semi-annual
floating rate bond with zero spread s is:

PFR t , T Z t , Ti 1 100 1 r2 Ti / 2

where Z(t,Ti+1) is the discount factor from t to Ti+1.

At reset dates, Z(Ti,Ti+1) = 1 + r2(Ti) / 2, which


PFR t , T 100
implies:

Inverse Floater
An inverse floater is a security that pays a lower
coupon as interest rates go up.
A fixed reference rate is used from which the floating
rate is subtracted.
For example, if an inverse floater promises to pay
15% minus the short-term interest rate on an annual
basis with three years maturity, the coupon on the
bond is:

C(t) = 15%-r1 (t-1)


Where r1 (t-1) denotes the annually compounded rate
at time t-1.

Inverse Floater
If it is assumed that the coupon is always positive,
the bond does not pay any coupon when the short
rate is more than 15%.
The coupon payments are a combination of a fixed
rate bond and a floating rate bond.
This is the same as having a long position in a fixed
rate bond and a short position in a floating rate
bond.
However, such a view would mean that at maturity,
the principal received from the fixed rate bond is
used to pay for the principal of the floating rate
bond

Inverse Floater
Thus, only a long position in a fixed rate bond and
a short position in a floating rate bond does not
mimic an inverse floater.
However, when a long position in a zero coupon
bond of the same maturity is added, the position
mimics an inverse floater.
Price of Inverse floater: PZ (0,3)+PC (0,3) PFR
(0,3)

Leveraged Inverse Floater


In the case of a leveraged inverse floater, the parity of
the floating rate to fixed rate is greater than one.
An example of a leveraged inverse floater is a bond
that pays a coupon of 25% minus two times the shortterm interest rate.
The coupon is given by:
C(t) = 25%- 2*r1 (t-1)
The portfolio that pays this cash flow would consist of
long two zero coupon bonds ,long a 25% fixed coupon
bond and short two floating rate bonds
Price of Leveraged Inverse floater: 2*P Z (0,3)+PC (0,3)
2*PFR (0,3)