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Introduction and Bond Pricing
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Teaching staff
• Lecturer in charge
– Dr. Elvira Sojli (Lectures 1‐3, 11)
Associate Professor
– Office hours: Tuesdays 16.00‐17.00 ASB 319
– Email: e.sojli@unsw.edu.au
• Co‐lecturer
– Dr. Shikha Jaiswal (Lectures 4‐10, 12)
– Office hours: Tuesdays 16.00‐17.00 ASB 319
– Email: shikha.jaiswal@unsw.edu.au
• Tutors
– I will put their contact info on Moodle
• Use Moodle discussion forum for course related
questions
Please check Moodle regularly 2
Textbook
• Main textbook: Bodie, Kane and Marcus Investments,
10th edition
• The custom book and the full hardback book are
equivalent
• You may use the 9th edition of the book
• You may or may not get by with an earlier edition of
the book, e.g. the 8th edition
• If you want to do additional exercises, you may want
to buy the solution manual associated with the book
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Lectures
• For each lecture, the course outline lists
essential readings (which you should really
try to read before the lecture) and
recommended readings (which is good to
read before the lecture)
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Today’s learning outcomes
• By the end of this lecture, you should
– be familiar with the basic set‐up of bonds
– be able to price a bond via no‐arbitrage
conditions (arbitrage pricing)
– be able to find the present value of a bond via
discounting future cash flows and link it to the
logic of arbitrage pricing
– be able to understand yield‐to‐maturity (YTM)
and other related yield/return measures and
calculate them
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What is a bond?
A bond is a To repay the money, the
certificate showing borrower has agreed to
that a borrower make interest and
owes a specified principal payments on
sum designated dates
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Bond Example
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Formal definition of bond
• Essentially a borrowing‐lending contract
– Three key parameters of a typical borrowing‐lending
contract: principal, maturity, and interest rate
• A bond is a claim on some fixed future cash flow(s), CF
– The bond matures at the time of its last cash flow, T
– Typically a “large” cash flow at maturity. We call this the
par value or face value (FV)
– There may be a series of smaller cash flows before
maturity. We call these coupons. There may be zero, one
or more coupons in a given year
– The sum of the annual coupons is often expressed as a
fraction of the FV, e.g. 5 %. We call this the coupon rate
(C). Let’s denote the actual coupon, e.g. $5, with ct, where
t is the period in which we get the coupon
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Cash flows of a bond
• This figure illustrates the cash flows of a
bond with a FV of 100 and a yearly coupon
of 5
‐P c1 c2
FV
‐91.3 5 5
100
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Default risk
• That somebody promises to pay you some
money doesn’t necessarily mean they will
• Complete markets
• Arbitrage pricing
– Replicate the future cash flows of an asset with a portfolio of
other assets with known prices (replicating portfolio)
– Under no‐arbitrage condition, the price of the asset under
question should equal to the market value of the replicating
portfolio
– We will use this approach when pricing bonds and
derivatives
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What is arbitrage?
• An arbitrage is a (set of) trades that generate zero
cash flows in the future, but a positive and risk free
cash flow today
– This is the proverbial “free lunch” or “money machine”
• A simple example exploits violations of the law of
one price, e.g. an identical bond selling for two
different prices
– Simultaneously buying the cheap bond and selling the
expensive bond would be an arbitrage trade
• All arbitrage pricing is priced based on the same
principle
– No‐arbitrage: securities with identical cash flows should
have the same price in the equilibrium (i.e., no ‘free
lunch’)
– but the trades are (slightly) more complex 17
Replicating portfolios
• We typically rely on a portfolio of assets that
exactly mimic the cash flows of some other
asset
• We call such portfolios replicating
portfolios or synthetic assets
• Arbitrage pricing is all about constructing
replicating portfolios using assets with
known prices
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Example: Pricing a zero‐coupon
bond
• How would you price the risk‐free one‐year
zero‐coupon bond below?
t t+1
Bond A
P=? 100
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Example: Pricing a zero‐coupon bond
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Example: Pricing a zero‐coupon bond (cont.)
• The appropriate discount rate, y, is the return we
could have earned at some alternative investment
with the same risk
– Let’s say there’s a bank where you can lend and borrow
money at 10% interest
• We want to make a synthetic version of the bond,
i.e. some investments that mimic its cash flows
exactly
– In this simple example we can just put some amount of
money, M, in the bank.
– After one year in the bank account earning 10%
interest, it should have grown to match the bonds cash
flow of $100
– We must have: 1.1M 100
100
M 90.9 21
1.1
Pricing a zero‐coupon bond:
Exploiting the mispricing
• What if the bond price differs from that, say, $80.9?
– The $90.9 bank deposit replicates the bonds cash
flow (is a synthetic bond) but has a different price
‐P c1 c2 ct cT
FV
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Pricing formula and yield‐to‐maturity
• From our previous discussions, we know
that the price of a bond could be determined
by discounting future cash flows:
– P = c1 /(1 + y1)1 + c2 /(1 + y2)2 + … + ct /(1 + yt)t
+ … + cT/(1 + yT)T + FV/(1 + yT)T
300
250
200
Price
150
100
50
0
0% 5% 10% 15% 20% 25%
YTM
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YTM and bond prices (cont.)
• The bond price decreases with the YTM
• When YTM = C = 10 %, P = FV = $100
– When P = FV (C = YTM), the bond trades at par
– When P < FV (C < YTM), the bond trades at a
discount
– When P > FV (C > YTM), the bond trades at a
premium
– C: $10 annual coupons
– YTM: 12% yield to maturity (you can do the calculation
and find a price of $96.62)
– Suppose we can reinvest the year 1 coupon at 10%
– The resulting (aggregate) cash flow at time 2 would be
CF2=100 + 10 + 10(1+0.1) = 121
– The realized compound yield would be:
(121/96.62)1/2 – 1 ~=11.9%.
• If the coupon can be reinvested at an interest rate that
equals the YTM, then the realized compound yield is
just YTM.
– But realized compound yield is very useful for comparing
two bonds when reinvestment rates differ from YTM. 37
An alternative interpretation of YTM
• Suppose you could reinvest all coupons at an
interest rate that equals the YTM
• The realized compound yield, i.e. your investment
return at the maturity of the bond, would equal the
YTM
• Although this is a common interpretation of the
YTM, the concept of YTM does not make any
assumptions on reinvestment rates.
– reinvestment rates will be determined by the market
and realized in the future
– YTM is determined by the (expected) interest rates for
all future horizons)
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