Académique Documents
Professionnel Documents
Culture Documents
Bond Pricing
t spot rate: fixed interest rate for an investment starting today and ending at time t
o Together, the spot rates make up the term structure of interest rates or the pure yield curve
o Denoted yt
Yield curve will take on different shapes at different times
o When next year’s spot rate is higher than today’s rate, the yield curve slopes upward
o When next year’s spot rate is less than today’s rate, yield curve slopes downward
At least in part, the yield curve reflects the market’s assessments of coming interest rates
The yield or spot rate on a long term bond reflects the path of short rates anticipated by the market
over the life of the bond
Spot rates of zero coupon bonds can be backed out using the following method:
1|Page
For two year bonds:
As there are two unknowns and one equation, the spot rates have to be backed out using
bootstrapping
(2) Substitute into equation for P2 – we now have one equation and one unknown
Arbitrage (pt 2)
(1) Back out implied term structure from pricing equations of bond A and B
(2) Use term structure to calculate arbitrage-free (or implied) price of bond C
Must achieve:
As each A bond gives CF1 = 100, synthetic bond containing XA A-bonds must satisfy:
Reinvestment risk
Whether longer term investor is willing to engage in a rollover strategy may be dependent on the
expected returns of the bond compared to that of the longer bond
o Unless they are certain of the final value of the rollover
o Generally would not be willing to hold short term bonds unless those bonds offered a
reward for bearing interest rate risk
If issuers typically have shorter investment horizons than investors, we’d get a downward sloping
term structure
Example: for a two year bond, where in the first year the bond is expected to have a spot rate of 5%
1.06 ¿2=(1.05)(1+ f 2 )
( 1.05 ) [ 1+ E ( r 2 ) ] >¿
Investor would require that expected value of next year’s short rate exceed the forward rate
Hence, if all investors were long-term investors, no one would be willing to hold short term bonds
unless those bonds offered a reward for bearing interest rate risk
Where spot rate valid at time 1 for an investment maturing at time 2 is denoted by 1y2, the cash flows at t=2
will be:
• Since 1y2 is unknown at t = 0, so is CF2 – as there is a risk here, the return made on the investment
is also risky
To emphasize that we mean the (risky) investment return, we sometimes refer to this as the holding period
return, HPR:
Forward rates
Def’n: interest rates for investments we agree on today but that take place in the future
o Denoted sft for a forward rate (determined today) that starts at time s and ends at time t
In the absence of arbitrage opportunities, the term structure determines all forward rates (and vice
versa)
Example: To determine the forward rate between year 2 and 3 (denoted 2f3)
a. Borrow
(2) Invest money borrowed for three years to achieve CF at t=3 of:
(3) As the CFs replicates the CFs of the forward rate, the t= 3 cash flows can be equated:
4|Page
Whether forward rates will equal expected future spot rates depends on investors’ readiness to bear
interest rate risk, as well as their willingness to hold bonds that do not correspond to their investment
horizons
Liquidity risk
Liquidity preference/preferred habitat theory: theory that liquidity premia determine the shape of
the term structure
When liquidity risk occurs: Arises where investment horizon is not matched with cash flows
When bond prices reflect a risk premium, the forward rate no longer equals expected spot rates
To persuade short-term investors to hold bonds with a longer maturity, a risk-averse investor would
be willing to hold the long-term bond only if the expected value of the spot rate is less than the
break-even value, f2
Example: suppose we have an investment horizon of one year and we hold a coupon bond maturing at t = 2,
we must sell it at t = 1 to achieve our period 1 cashflow
P1 = (c + FV)/(1 + 1y2)
Though in principle we could pick a bond with a maturity matching our horizon, markets must clear
and somebody must carry some risk
Liquidity premium: premium offered to induce investors to hold bonds whose maturity does not
match their horizon (risk is given a price)
If issuers typically have a longer investment horizons than investors, we’d get an upwards sloping
term structure
Expectations Hypothesis
Theory: market expectations on future interest rates shape the term structure
o Forward rate equals the market consensus expectation of the future short interest rate
o Liquidity premiums are zero
YTM are determined solely by current and expected future one-period interest rates
o Upward sloping yield curve would be clear evidence that investors anticipate increases in
interest rates
5|Page
Consolidating the two theories
L is the liquidity premium the market demands to hold bonds of that maturity
Term structures can infer the expectations of other investors in the economy, and can also be used
as benchmarks for analysis
Complexities in interpreting the term structure
o While yield curve does reflect expectations of future interest rates, it also reflects other
factors such as liquidity premiums
o Forecasts of interest rate changes may have different investment implications depending on
whether those changes are driven by changes in expected inflation rate or real rate
Factors accounting for rising yield curve
o Where forward rate for coming period is greater than yield at that maturity: y1 < y2 < 1f2
o Where investors demand a premium for holding longer-term bonds
However, note that a rising yield curve does not in and of itself imply expectations of higher future
interest rates possibility of liquidity premiums confound simple attempt to extract expectations
from the term structure
Factors accounting for a falling interest rate (falling yield curve)
o There are two factors to consider – real rate and inflation premium
o Expected change in interest rates can be due to changes in either expected real rates or
expected inflation rates
6|Page