Fall 2011

Bond and Interest Rate Basics

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BUSM 411: Derivatives and Fixed Income 4.

4.1.

Bond and Interest Rate Basics

Discount Factors

Receiving a dollar today is not the same as receiving it in a month or in a year. Money today can be put in a safe place (a bank, under the mattress), but the opposite is not easily doable Money in hand gives the holder the option to use it however he/she desires, including transferring it to the future through deposit or investment How much is $1 in the future worth today? This value is called the discount factor The notion of discount factors is at the the heart of xed income securities (and of any other security) As a concrete example, the US government needs to borrow money from investors to nance its expenses. It does so by issuing a number of securities, such as Treasury bills, notes, and bonds, to investors, receiving money today in exchange for money in the future. The US Treasury is extremely unlikely to default on its obligations (why?), so the relation between the purchase price and the payo of Treasury securities reveals the market time value of moneythat is, the exchange rate between money today and money in the future Example: On August 10, 2006, the Treasury issued 182-day (six month) Treasury bills. The market price was $97.477 for $100 of face value. This bill would not make any other payment between the two dates. Thus, the ratio between purchase price and payo, 0.97477 = $97.477/$100, can be considered the market-wide discount factor between the two dates August 10, 2006 and February 8, 2007. That is, market participants were willing to exchange 0.97477 dollars on the rst date for 1 dollar six months later. Notation: The discount factor between dates t1 and t2 , that is, that price on date t1 to receive $1 on date t2 , can be denoted by Z (t1 , t2 ). 1

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Bond and Interest Rate Basics

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If you have a future cash ow at time t, Ct , you can multiply it by the discount factor Z (0, t) to obtain the present value of the cash ow. 4.1.1 Discount factors across maturities

The example and notation above highlight that the discount factor at some date t1 depends on its maturity t2 . If we vary the maturity, making it longer or shorter, the discount rate varies as well. For the same reason investors value $1 today more than $1 in six months, they also value $1 in three months more than $1 in six months. Example: On August 10, 2006, the Treasury also issued 91-day (three month) Treasury bills. The market price was $98.739 for $100 of face value. If we denote t1 = August 10, 2006, t2 = November 9, 2006, and t3 = February 8, 2007, we nd that the discount factor Z (t1 , t2 ) = 0.98739, which is higher than Z (t1 , t3 ) = 0.97477 FACT: At any given time t1 , the discount factor is lower the longer the maturity t2 . That is, given two dates t2 and t3 with t2 < t3 , it is always the case that Z (t1 , t2 ) Z (t1 , t3 ) 4.1.2 Discount factors over time

A second important characteristic of discount factors is that they care not constant over time, even while keeping constant the time-to-maturity t2 t1 . As time goes by, the time value of money changes. For example, the Treasury issued a 182-day T-bill on August 26, 2004, for a price $99.115, which implies a discount factor much higher than that for the same time-to-maturity two years later. Why do discount factors vary over time? Most obvious and intuitive reason is that expected ination varies over time. Other explanations are related to the behavior of the US economy, its budget decit, and the actions of the Federal Reserve, as well as investors change appetite for risk. These macroeconomic conditions aect the relative supply and demand of Treasury securities and thus their prices. 2

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Bond and Interest Rate Basics

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4.2.

Interest rates

Grasping the concept of a rate of interest is both easier and more complicated than the concept of a discount factor Easier because interest is closer to our everyday notion of a return on an investment, or the cost of a loan. For instance, if you invest $100 for one year at an annual interest rate of 5%, you receive in one year $105. The discount factor is $100/$105 = 0.9524. It carries the same information as the interest rate, but perhaps less intuitively descries the return on investment. More complicated because it depends on the compounding frequency of the interest paid on the initial investment. The compounding frequency of interest accruals refers to the number of times per year in which interest is paid and reinvested on the invested capital Mentioning only an interest rate is an incomplete description of the rate of return of an investmentthe compounding frequency is a crucial element that must be attached to the interest rate gure In the above example, we implicitly assumed that the 5% rate of interest is applied to the original capital only once (hence the $105 result). What if interest accrues every 6 months? What if interest accrues every 12 months? FACT: For a given interest rate gure (e.g. 5%), more frequent accrual of interest yields a higher nal payo FACT: for a given nal payo, more frequent accrual of interest implies a lower interest rate gure 4.2.1 Discount factors, interest rates, and compounding frequencies

Discount factors and interest rates are intimately related, once we make explicit the compounding frequency Two compounding frequencies are particularly important: Semi-annual compounding, because it matches the frequency of coupon payments of US Treasury notes and bonds Continuous compounding is also important, mainly for analytical convenience

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Example: Let t1 = September 19, 2011 and let t2 = September 19, 2012 (one year from now). Consider an investment of $100 today at the semi-annually compounded rate of interest r = 5%, for one year. This means the investment grows by 5%/2 = 2.5% every six months, so that at t2 the payo is Payo at t2 = $100 (1 + r/2) (1 + r/2) = $100 (1 + r/2)2 = $105.0625 The relation between money at t1 and money at t2 establishes a discount factor between the two dates, given by Z (t1 , t2 ) = 1 $100 = payo at t2 (1 + r/2)2

More generally, let n be the number of times per year that interest accrues, and let rn (t1 , t2 ) be the (annualized) n-times compounded interest rate. Given the discount factor Z (t1 , t2 ), rn (t1 , t2 ) is dened by the equation Z (t1 , t2 ) = 1+ Solving for rn (t1 , t2 ) gives rn (t1 , t2 ) = n 1
1

1
rn (t1 ,t2 ) n n(t2 t1 )

Z (t1 , t2 ) n(t2 t1 ) The continuously compounded interest rate is obtained by increasing the compounding frequency n to innity. It is given by the formula Z (t1 , t2 ) = exprcc (t1 ,t2 )(t2 t1 ) Solving for rcc (t1 , t2 ), we obtain rcc (t1 , t2 ) = ln(Z (t1 , t2 ) t2 t1

Given a discount factor, we can dene interest rates of any compounding requency by using the above equations. In order to compare apples to apples, we often use the eective annual rate, dened as the reciprocal of the discount factor minus one

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4.3.

Coupon bonds

US government treasury bills involve only one payment from the Treasury to the investor at maturitytheir coupon rate is zero Knowing the price of zero coupon bonds allows us to easily determine the discount factor for the maturity of the bond: Pz (t1 , t2 ) = 100 Z (t1 , t2 ) The Treasury issues zero coupon bonds for maturities up to only 52 weeks. For longer maturities, the Treasury issues securities that carry a coupon. That is, they pay a series of cash ows (the coupons) between the issue date an maturity, in addition to the nal principal. 4.3.1 From zero coupon bonds to coupon bonds

Note that a coupon bond can be represented by the sequence of its cash payments For example, consider a 2-year 4.375% Treasury note issued in Sepctember of 2011. What is the sequence of cash ows? Given the sequence of cash ows, we can compute the value of the bond if we know discount factors for each of the four payment dates
n n

Bt (t, T, c, n) =
i=1

c 100 Z (t, ti ) + 100 Z (t, T ) =

i=1

cPz (t, ti ) + Pz (t, T )

In the example above, suppose te 6-month, 1-year, 1.5-year, and 2-year discount factors are 0.97862, 0.95718, 0.936826, and 0.91707, respectively. What should the price of the bond be? A bond which trades at a price of $100 is said to be at par No arbitrage argument for bond pricing based on zero coupon rates: suppose the bond in the above example were trading at $98. How could you take advantage of this situation? 4.3.2 From coupon bonds to zero coupon bonds

We can also go the other way around: If we have enough coupon bonds, we can compute the implicit value of zero coupon bonds from the prices of the coupon bonds 5

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Example: in June 2005 (t), the 6-month T-bill, expiring in December of 2005 (T1 ), was trading at $98.3607. On the same date, the 1-year, 2.75% note was trading at $99.2343, which matured at T2 = June 2006. What is the 6-month zero coupon price? What is the 1-year zero coupon price? Suppose that on the same date, a 3% note maturing in December 2006 trades at $99.1093. What is the 1.5-year zero coupon price? This procedure is called bootstrapping, and can be used as long as we have as many distinct bonds (i.e. dierent coupons) as there are maturities for which we need to nd discount factors. 4.3.3 Expected return and yield-to-maturity

How can we measure the expected return on an investment in Treasury securities? Assuming the investor will hold the bond until maturity, computing the expected return on an investment in a zero coupon bond is straightforward (it is the reciprocal of the discount factor, minus 1). For coupon bonds it is more complicated. A popular measure is yield-to-maturity ym , which is the internal rate of return on the bond. It is dened by
n

Bt (t, T, c, n) =
i=1

1 c + i (1 + ym ) (1 + ym )n

Note that the yield-to-maturity is the return the investor would earn if he holds the bond to maturity. If he buys a 10-year note and sells it after one year, however, his realized return may be higher or lower than what the YTM was when he bought the note, and will depend on how interest rates change over the course of the year. Thus, YTM is not really the expected return from buying and holding the bond, but is really just a convenient way of quoting a bond price.