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What is it?
Spot rate:
Short rate:
Generally,
t
(1 + y ) = ∏ (1 + ri )
(t ) t
i =1
t
⇒y (t )
= [∏ (1 + ri )]1/ t − 1
i =1
( ) (1 + r )
n −1
(1 + y ( n ) ) n = 1 + y ( n −1) n
(1 + y ( n ) ) n
(1 + rn ) =
(1 + y )
n −1
( n −1)
Forward Rates (under certainty)
(1 + y ( n ) ) n
⇒ (1 + f n ) =
(1 + y ( n −1) ) n −1
(1 + y ( n ) ) n
⇒ (1 + f n ) =
(1 + y ( n −1) ) n −1
we know, f2 ≈ 10.01%.
Cash-Flow
Zero at t = 0
Positive when we want the loan, at t = 1
Negative when we repay, t = 2.
Strategy
t=0
• Buy a single one-period zero at P(1)
• Sell (1+ f2) times the two period spot at P(2)
• Note, our cash flow is zero at t= 0. [925.93-
925.93=0].
t=1
• Receive M for our one-period zero, i.e. 1000.
t=2
• Must pay back the liability incurred by selling
f2 times the two-period spot: (1+f2)*M =
1.1001*1000 = 1100.1.
Conditional Expectations:
Preferences
Investors’ preferences may become an important
determinant of asset valuation in a world of uncertainty.
In particular, agents may be risk averse, which implies
that a certain return is preferred to an uncertain
(expected) return.
Also, they may have preferences about the length of
time they are invested in a project, e.g. short- vs. long-
term investors.
If such an investor had to choose between a long-
run, but uncertain investment and a short-term but certain
investment that offers the same return, he would choose
the short-term investment.
(1) Pt (n)
= + + ... + = ∑ Vi
(1 + rst(1) ) (1 + rst(2) ) (1 + rst( n ) ) n i =1
If this were not so, then arbitrage would allow for risk-
less profits, i.e. we could sell the rights to the payments.
Why?
⎡ Pt (+n1−1) − Pt ( n ) + Ct +1 ⎤
Et ⎢ (n) ⎥ = kt
⎣ Pt ⎦
This can be solved forward to give the current bond price
as the discounted present value of future coupon
payments discounted at the expected one-period spot
returns kt+i.
⎡ ⎤
⎢ n Ct + j M ⎥
Pt ( n ) = Et ⎢ ∑ j −1 + n −1 ⎥
(2) ⎢ j =1 ⎥
⎢ ∏ (1 + kt +i ) ∏ (1 + kt +i ) ⎥
⎣ i =o i =0 ⎦
k t + i ≡ rt + i + Tt (n )
+ i (i > 1).
(1) and (2) will provide the same price on a two period
bond if:
(1 + rs (1) ) = (1 + k0 )
(1 + rs (2) ) 2 = (1 + k0 ) Et (1 + k1 )
⇒ Et (1 + k1 ) = (1 + rs (2) ) 2 (1 + rs (1) )
E t H t(+n1) − rt = T ( n )