Seminar 3

Discount Rates & Yield Curves (Lecture Notes Recap)

1) Spot bond – Zero coupon bond (One payment at maturity)

FV
FV

Time
Time
Yr 0
Yr 4 (Maturity Year)

2) Annuity bond – Constant cash flow at regular intervals

CF CF CF CF

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Time

3) Par bond – Pays coupons and Principal amount

FV

CF CF CF CF

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Time

What are the similarities among the 3 bonds above?

Spot bond + Annuity bond = Par Bond
Spot Yields to Annuity Yields

Time Spot Annuity Par C (YTM)

1 5 5 5
2 6 5.65 5.97 5.97
3 7.5 6.524 7.36 7.36
Figures indicated in RED are calculated in the below steps before imputing in. For the
first year, cash flows on both types of bonds are identical. Therefore, Annuity Yield for 1st
Year is also 5%.

CF CF

Time
Yr 0 Yr 1 Yr 2
Discount the annuity
yields to present value.

Calculate the PV of the 2-year annuity which gives $1 each year :

1 1
PV = +
(1+ S1) (1+ S2) 2
1 1
= + 2
(1+ 0.5) (1+ 0.6)

PV (Annuity) = 1.8424

Calculate the Returns on Annuity for year 1 and 2 (R2) at the bond price of $1.8424
1 1
PV (Annuity) = + 2
(1+ R2) (1+ R2)

R2 = 5.65%
 CF CF CF

Yr 0 Yr 1 Yr 2 Yr 3 Time
Discount the annuity
yields to present value.

1 1 1
PV = + 2 + 3
(1+ S1) (1+ S2) (1+ S3)
Substitute
S1= 5
S2 = 6
S3 = 7.5

PV of Annuity = 2.6473
1 1 1
PV (Annuity) = + 2 + 3
(1+ R3) (1+ R3) (1+ R3)

R3 = 6.524%
Spot Bond to Par Bond

For the first year, cash flows on both types of bonds are identical. Therefore, Par Yield for
1st Year is also 5%.

a) Determine the 2 year par yield (ie, YTM for a 2 year par bond) :

C C

Time
Yr 0 Yr 1 Yr 2

Px = 100 (Price of bond = 100, or the face value because it is a par bond)

100 = C/(1+S1) + (C+P)/(1+S2) 2

100 = C/ (1+0.05) + (C+100)/(1+0.06) 2
C = 5.97
Where
P = 100
S1 = 5%
S2 = 6%

Therefore, for par bond, coupon rate = YTM. Therefore, 2 year par yield = C = 5.97

b) Determine the 3-year par yield (ie, YTM for a 3 year par bond) :

Px = 100
100 = C/(1+S1) + C/(1+S2) 2 + (C+P)/(1+S3) 3
C = 7.36
Where
P = 100
S1 = 5%
S2 = 6%
S3 = 7.5%

Therefore, for par bond, coupon rate = YTM. Therefore, 3 year par yield = C = 7.36
Par Bond to Spot Bond

Figures indicated in RED are calculated in the below steps before imputing in. For the
first year, cash flows on both types of bonds are identical. Therefore, Spot Yield for 1st
Year is also 6%.

Time (t) Spot Par

1 6% 6
2 7.035% 7
3 9.22% 9

a) Determine the 2-year spot yield, ie, S2 from a 2-year par bond :

C C

Yr 0 Yr 1 Yr 2 Time

Px = 100 (Price of bond = 100, or the face value because it is a par bond)

Px = C/(1+S1) + (C+P)/(1+S2) 2
100 = 7/(1+0.06) + (7+100)/( 1+S2) 2
where
Px = 100,
C = 7 (2-year par bond’s YTM = 7% = coupon rate),
P = 100
S1 = 6%

Therefore, S2 = 7.035
a) Determine the 3-year spot yield, ie, S3 from a 3-year par bond :

C C C

Yr 0 Yr 1 Yr 2 Yr 3 Time

Px = 100 (Price of bond = 100, or the face value because it is a par bond)

Px = C/(1+S1) + C/(1+S2) 2 + (C+P)/(1+S3) 3

100 = 9/(1+0.06) + 9/( 1+0.0735) 2 + (9 + 100)/( 1+S3) 3
where
Px = 100,
C = 9 (3-year par bond’s YTM = 9% = coupon rate),
P = 100,
S1 = 6%,
S2 = 7.035%.

Therefore, S3 = 9.22%