Lecture 02:

Fixed Income Securities Zeroes and Coupon

Prof. Jerchern Lin
Bonds

Zeroes
Coupon Bonds

Readings:
TUCKMAN Chapters 1 and 2
MARTELLINI Chapters 1, 2, and 4

1
 Questions/Summary
What is the discount factor? Price? Of what?
Are discount factors the same as zero bonds?
What is the relationship between interest rates and discount factors?
If you are given the zero rate how do you compute the zero price?
How would you do the opposite?

What is the term structure?

What are the possible shapes of the term structure?

How do you price coupon bonds? (replication)

What are the advantages of pricing by replication when we also
have a simple pricing formula in hand?
What is that pricing formula?

How can you get the zero prices from coupon bond prices?
2
 Outline
Bond pricing basics

A. The discount function

B. Valuing fixed cash flows
C. Yields
D. Forward rates
E. Term structure theories

3
Key Concepts and Buzzwords

Topics Buzzwords
Zero-coupon bonds Zeroes, STRIPS, semi-
annual compounding
Zero Rates or Spot Rates

4
 Interest Rates

People try to summarize information about bond prices

and cash flows by quoting interest rates.
The convention in U.S. bond markets is to use semi-
annually compounded interest rates.

5
 Annual vs. Semi-Annual
Compounding
At 10% per year, annually compounded, $100 grows to $110
after 1 year, and $121 after 2 years:

10% per year semi-annually compounded really means 5%

every 6 months. At 10% per year, semi-annually
compounded, $100 grows to $110.25 after 1 year, and
$121.55 after 2 years:

6
 Annual vs. Semi-Annual
Compounding...
After T years, at annually Present value of F to be received
compounded rate rA, P in T years with annually
grows to compounded rate rA is

In terms of the semi-annually compounded rate r, the

formulas become

A semi-annually compounded rate of "r" per year

really means "r/2" every six months. 7
 ZEROES
(Interest rates,
Prices)

8
 Discount Factor

The most basic debt instrument is a zero-coupon

bond. Because of the time value of money, a dollar
today is worth more than a dollar received in the future,
so the price of a zero is always less than its face value.
Let
dt
denote the t-period discount factor, i.e., the price today
of an asset that pays $1 in t periods.

9
 Discount Factors: Example
US Strips Market

6-month 97.30
1-year 94.76
1.5-year 92.22
2-year 89.72
5-year 75.41

10
Discount Factors: Example

US Strips Market
11
 Zero Rates or Spot Rates of
Interest
Call rt the t-year zero rate or discount rate or spot rate.

Spot rate: the t-year spot rate is the semiannually compounded

rate of return implied by the market price of the t-year zero.

Discount factors and spot rates of interest are closely related:

1
dt =
(1 + rt / 2) 2t

1
1 2
= 2 1

12
 Trading Zeroes Mean

Buying a zero is lending money, i.e., you pay money now

and get money later

Selling a zero is borrowing money, i.e., you get money

now and pay later

13
 Zero Rates: Example
US Strips Market

r 0.5
=
r 1 =
r 5
=

14
 Zero Rates: Example
US Strips Market

1
1 1
0.5 = 2 1 =
0.9730
1
1 2
1 = 2 r 1 =
0.9476
1
1 10
5 = 2 1 =
0.7541

15
 Zero Rates: Example
US Strips Market

. = 2 = 5.54 %
.


= 2 r = 5.45 %
.


= 2 = 5.73 %
.

16
Term Structure of Interest Rates

The relation between spot rates and time to maturity is

called the term structure of interest rates (also known as
the spot, yield, or zero curve).

17
 The Spot Curve

6.5

Spot Cve
6

5.5

5
0 5 10 15 20 25 30

US Strips Market
18
 Yield Curve Shapes

Upward

19
 Yield Curve Shapes

Upward

20
 Yield Curve Shapes

Upward Downward (Inverted)

21
 Yield Curve Shapes

Upward Downward (Inverted)

Humped 22
 Yield Curve Shapes

Upward Downward (Inverted)

Humped Flat 23
The Spot Curve: 1/9/98-1/7/00

6 1/9/1998
1/11/1999
5 1/7/2000

4
3mo 6mo 1yr 2yr 3yr 5yr 7yr 10yr 15yr 20yr 30yr

24
 Bond Markets
Strips/Zero market

Prices of Zeros

Zero Rates

25
Coupon Bonds
(Prices)

26
 Outline
Bond pricing basics

A. The discount function

B. Valuing fixed cash flows
C. Yields
D. Forward rates
E. Term structure theories

27
Key Concepts and Buzzwords

Topics Buzzwords
Bond Replication Dedication, implied zeroes,
No Arbitrage Price Relationships

28
 Bond Markets
Strips/Zero market Bond market

Prices of Zeros Prices of Coupon

Bonds

Zero Rates

29
Securities with Fixed Cashflows:
Overview
Conceptually, the "zeroes" are the building blocks of all
securities with fixed cash flows.
Combining zeroes in a portfolio creates an asset with
multiple fixed cash flows.
We can structure portfolios of zeroes to replicate
existing securities, such as coupon bonds.
It is also possible to construct a portfolio of coupon
bonds that replicates a zero.
The possibility of replicating one asset from a portfolio of
others means that, in the absence of arbitrage, their
prices must be related.
30
A Coupon Bond as a Portfolio of
Zeroes
Example: $10,000 par of a 1.5 year, 8.5% T-bond makes
the following payments:

6 months 1 year 1 1/2 years

$425 $425 $10425

This is the same as a portfolio of three different zeroes:

$425 par of a 6-month zero
$425 par of a 1-year zero
$10425 par of a 1 1/2-year zero

31
 The Principle of No Arbitrage or
Law of One Price
Two assets which offer exactly the same cash
flows must sell for the same price.

Why?

32
 The Principle of No Arbitrage or
Law of One Price

Two assets which offer exactly the same cash

flows must sell for the same price.

Why? If not, then one could buy the cheaper asset

and sell the more expensive, making a profit today
with no cost in the future. This arbitrage opportunity
cannot persist in equilibrium.

33
 Valuation by Replication

The previous example shows that we can construct a

coupon bond from zeros. Therefore, given a set of
discount factors, we can value a coupon bond by valuing
the portfolio of zeros that replicates its cash flows.

34
Valuing a 1.5-Year, 8.5% T-Note

V =$425d.5 +$425d1+$10425d1.5
Maturity Priceof$100 Discount BondCash Value
ParofZero Factor Flow

0.5 $97.30 0.9730 $425 $414

1.0 $94.76 0.9476 $425 $403
1.5 $92.22 0.9222 $10425 $9614

Total $10430

On the same day, the WSJ priced a 1.5-yr 8.5%-cpn

bond at 104 10/32 (=104.3125). 35
 An Arbitrage Opportunity
What if the 1.5-year 8.5% coupon bond were worth only
104% of par value?

You could buy, say $1 million par of the bond for

$1,040,000 and sell the cash flows off individually as
zeroes for total proceeds of $1,043,000, making $3000
of riskless profit.

Similarly, if the bond were worth more than 104.3% of

par, you could buy the portfolio of zeroes, reconstitute
them, and sell the bond for riskless profit.
36
 The General Apporach
Suppose we have an asset whose cash flows are KNOWN and
RISK-FREE.
Then, by no arbitrage, the market value of the asset must be:

1 2
= 1 + 2 2
++
1+ 1+ 1+
2 2 2
= 1 1 + 2 2 + +
 Application: Synthetic Bonds
A synthetic bond is a portfolio of securities that is
constructed to produce a specific pattern of cash flows

Uses
exploit mispricing (conversion arbitrage)
hedge a series of future cash flows
price complex securities by replication

38
Constructing Zeroes from Coupon
Bonds
Not only can we construct a given bond from zeroes, we
can also go the other way.

Example: Constructing a 1-year zero from 6-month and

1-year coupon bonds.
Coupon Bonds:

Bond# Maturity Coupon Price in Price in

32nds Decimal
1 0.5 4.250% 99-13 99.40625
2 1.0 4.375% 98-31 98.96875
39
Constructing the One-Year Zero
Find portfolio of bonds 1 and 2 that replicates 1-year zero.

Let N1 be the number (par value) of bond 1 and N2 be the number

of bond 2 in the portfolio.

At time 0.5, the portfolio will have a cash flow of

N1 x (1+0.0425/2) + N2 x 0.04375/2

At time 1, the portfolio will have a cash flow of

N1 x 0 + N2 x (1+0.04375/2)
We need N1 and N2 to solve

N1 x (1+0.0425/2) + N2 x 0.04375/2 =0

N1 x 0 + N2 x (1+0.04375/2) =100
=> N2 = 97.86 and N1 = -2.10
40
 Implied Zero Price
The price of the replicating portfolio,
long 97.86 par value of the 1-year bond
short 2.10 par value of the 0.5-year bond,
is (97.86 x $0.9896875) - (2.10 x $0.9940625),
or $94.7665.

In the absence of arbitrage, with no market frictions, this

must be the price of the 1-year zero

Note that the price of the 1-year STRIP is $94.76

41
 Inferring Zero Prices from Bond
Prices: Shortcut
The last example showed how to construct a portfolio of bonds that
synthesized (had the same cash flows as) a zero.
We concluded that the zero price had to be the same as the price of
the replicating portfolio (no arbitrage).
If we don't need to compute the replicating portfolio, we can solve
for the implied zero prices more directly:

42
 Market Frictions
In practice, prices of Treasury STRIPS and Treasury
bonds don't fit the pricing relationship exactly
transaction costs and search costs in stripping and reconstituting
bid/ask spreads

Note: The terms "bid" and "ask" are from the viewpoint of
the dealer
dealer buys at the bid and sells at the ask, so the bid price is
always less than the ask.
The customer sells at the bid and buys at the ask.

43
 Liquidity Matters

Often people would rather work with Treasury coupon

bonds than with STRIPS, because the market is more
active.

They can imply a discount function from Treasury bond

prices instead of STRIPs and use this implied discount
function to value more complex securities.

44
 Replication Possibilities
Since we can construct zeroes from coupon bonds, we
can construct any stream of cash flows from coupon
bonds.

Uses
Bond portfolio dedication--creating a bond portfolio that has a
desired stream of cash flows
funding a liability
Taking advantage of arbitrage opportunities

45
 Questions/Summary
What is the discount factor? Price? Of what?
Are discount factors the same as zero bonds?
What is the relationship between interest rates and discount factors?
If you are given the zero rate how do you compute the zero price?
How would you do the opposite?

What is the term structure?

What are the possible shapes of the term structure?

How do you price coupon bonds? (replication)

What are the advantages of pricing by replication when we also
have a simple pricing formula in hand?
What is that pricing formula?

How can you get the zero prices from coupon bond prices?
46