Economics 122

FINANCIAL ECONOMI CS (DE BT S ECURITIES 2)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

SOURCE: BODIE ET AL. (2009), ROSS ET AL., LO (2008)

Valuation (bond pricing)
 Components of valuation
o Time value of principal and coupons
o Risks
• Inflation
• Credit risk
• Timing (callability)
• Liquidity
• Currency

 For the moment, suspend disbelief, and consider only riskless debt
(Treasuries?)
• Will tackle risky debt later.
Valuation (bond pricing)
 Cash flow
o Coupon
o Principal
 Example: A 3-year bond with principal of $1,000 and annual coupon payment
of 5% has the following cash flow:
$50 $50 $50 + $1,000

t=0 t=1 t=2 t=3

Valuation of discount bonds
 Pure discount bond
o No coupons – single payment of principal at maturity
FV

t=0 T
o Bond  trades  at  a  “discount”  to  face  value  (like  T-bills).
o Also known as zero-coupon  bonds  or  “STRIPS”  (acronym  for  separate  trading  of  
registered interest and principal securities).
o Valuation is straightforward calculation of present value:
𝐹𝑉
𝑃 =
1+𝑟
Valuation of discount bonds
o Ex. If you have a 5-year STRIP selling for $0.80 (FV of $1), what would be the 5-year
spot rate?
$1
$0.80 =
1+𝑟 ,
1
0.80 =
1+𝑟 ,
1.25 = 1 + 𝑟 ,
𝑟 , = 4.56%
o You can do the same for the rest of the example:
Maturity 1 year 2 years 5 years 10 years 30 years

Price (spot rate) $0.97 $0.93 $0.80 $0.60 $0.19

(3.09%) (3.69%) (4.56%) (5.24%) (5.69%)
Valuation of discount bonds
 Point to ponder: What if interest rates vary over time?
 If 𝑟 varies over time (different from one year to the next)
o Denote by 𝑅 the 1-year spot rate of interest in year 𝑡 (i.e., the ‘short  rate’)
𝐹𝑉
𝑃 =
1+𝑅 1+𝑅 … 1+𝑅
o However,  we  can’t  observe  the  entire  sequence  of  future  spot  rates  today.
𝐹𝑉 𝐹𝑉
𝑃 = =
1+𝑅 1+𝑅 … 1+𝑅 1+𝑟 ,
o We can think of 𝑟 , as today’s  T-year spot rate of interest or the current spot
rate,  which  is  an  “average”  of  1-year future spot rates.
Valuation of discount bonds
 Suppose we observe several discount bond prices today
𝐹𝑉 𝐹𝑉
𝑃 , = = →𝑟 ,
1+𝑅 1+𝑟 ,
𝐹𝑉 𝐹𝑉
𝑃 , = = →𝑟 ,
1+𝑅 1+𝑅 1+𝑟 ,
𝐹𝑉 𝐹𝑉
𝑃 , = = →𝑟 ,
1+𝑅 1+𝑅 1+𝑅 1+𝑟 ,
⋮
𝐹𝑉 𝐹𝑉
𝑃 , = = →𝑟 ,
1+𝑅 1+𝑅 1+𝑅 … 1+𝑅 1+𝑟 ,
 This gives the term structure of interest rates! (Yield curve)
𝑃 , ,𝑃 , ,…,𝑃 , → 𝑟 , ,𝑟 , ,…,𝑟 ,
Valuation of discount bonds
 Graphing the term structure (yield curve):
r INVERTED YIELD CURVE:
-Sign of Recession

T
Valuation of discount bonds
Valuation of discount bonds
 The term structure contains information about future interest rates
𝐹𝑉 𝐹𝑉
𝑃, = =
1+𝑅 1+𝑟 ,
𝐹𝑉 𝐹𝑉
𝑃, = =
1+𝑅 1+𝑅 1+𝑟 ,
𝑃,
= 1+𝑅
𝑃,
 Implicit in current bond prices are forecasts of future spot rates!
Valuation of discount bonds
 These current forecasts are called 1-year forward rates.
 To distinguish them from spot rates, let us use new notation (𝑓 ):
𝑃, 1+𝑟 ,
= = 1+𝑓
𝑃, 1+𝑟 ,
Synthetic forward loan
 In general, forward rates will not equal the eventually realized short rate
o Still an important consideration when trying to make decisions:
• Locking in loan rates

 Example of a strategy:
o Sell 1 + 𝑓 2-year zeros for every 1-year zero you buy
𝑃 , × 1+𝑓 $FV Pay an amount
$FV× 1 + 𝑓 for the
=𝑃,
1 + 𝑓 units of the 2-
Net cash year zeros sold
out at
time 1 is
t=0 t=1 t=2
Receive face
zero value of 1-
year zero
-𝑃 , $FV× 1 + 𝑓
equal to $FV
Synthetic forward loan
o Using numbers in the earlier example:
𝑃, $970
1+𝑓 = = = 1.043 ⇒ 𝑓 = 0.043
𝑃, $930
o Note  how  you  effectively  did  “borrow”  $1,000  a  year  from  now  and  repay  $1,043  2  years  later  
— in finance parlance, you created a synthetic forward loan by  which  you  “locked  in”  the  
(forward) rate!

$930 × 1 + 0.043 = +$970 Receive $1,000 FV

(sell 1.043 units of 2-yr zeros) from the 1-yr zero

Net cash
out at
time 1 is t=0 t=1 t=2
zero

-$970 (buy 1- Pay an amount $1,043 [= $1,000 × 1.043 ]; for the 1.043
units of 2-yr zeros earlier sold (you repay your $1K debt!)
yr zero)
Valuation of coupon bonds
 Coupon bonds
o Introduce intermediate payments in addition to the final principal payment.
o Coupon bonds can trade at discounts or premiums to face value (sell lower than FV
or sell higher).
o Simply apply the NPV equation to get their valuation.
C + FV
C C

t=0 t=1 t=2 … t=T …

Valuation of coupon bonds
 PV equation to value a coupon bond:
𝐶 𝐶 𝐶 +𝐹
𝑃 = + +⋯+
(1 + 𝑅 ) (1 + 𝑅 )(1 + 𝑅 ) 1+𝑅 1+𝑅 … 1+𝑅
 Since future spot rates are unobservable, simply summarize them with 𝑦𝑡𝑚, or
the yield to maturity of a bond:
𝐶 𝐶 𝐶+𝐹
𝑃 = + +⋯+
(1 + 𝑦𝑡𝑚) (1 + 𝑦𝑡𝑚) (1 + 𝑦𝑡𝑚)
 𝑦𝑡𝑚 is a complex average of all future spot rates (interpreted as a measure of
the average rate of return that will be earned on a bond if it is bought and held
until maturity).
 For pure discount bonds, 𝑦𝑡𝑚 is the current spot rate.
 Graphing the 𝑦𝑡𝑚 of coupon bonds against maturities gives the yield curve.
Valuation of coupon bonds
 Another valuation method for coupon bonds
o All coupon bonds are portfolios of pure discount bonds.
o Valuation of discount bonds implies valuation of coupon bonds.
 Example:
o 3-year 5% bond
o Sum of the following discount bonds:
• 50 1-year STRIPS
• 50 2-year STRIPS
• 1050 3-year STRIPS
Valuation of coupon bonds
 Example:
o 3-year 5% bond
o Sum of the following discount bonds: 50 1-year STRIPS, 50 2-year STRIPS, 1050 3-year
STRIPS $50 (50 1-year
STRIPS)

t=0 t=1 $50 (50 2-year time

STRIPS)

t=0 t=2 $1050 (50 3-year time

STRIPS)

t=0 t=3 time

Valuation of coupon bonds
o Price of the 3-year bond must equal the cost of this portfolio (50 1-year STRIPS, 50
2-year STRIPS, and 1050 3-year STRIPS)
o What if it does not?
• Arbitrage! No risk, positive profits.
o In general:
𝑃 = 𝐶𝑃 , + 𝐶𝑃 , + ⋯ + (𝐶 + 𝐹)𝐶𝑃 ,
o If this relation is violated, arbitrage opportunities exist.
o For example, suppose that:
𝑃 > 𝐶𝑃 , + 𝐶𝑃 , + ⋯ + (𝐶 + 𝐹)𝑃 ,
o Strategy: Short the coupon bond, buy C discount bonds of all maturities up to T
and F discount bonds of maturity T!
Bonds subject to interest rate risk
 The main risk to bonds is interest rate risk.
 As interest rates change, bond prices also change.
 Sensitivity of price to changes in yield measures risk.
 Long-maturity bonds are the most vulnerable to such risk because of the
power of discounting (i.e., greatest sensitivity of price to interest rate
fluctuations).
 T-bills considered to be safest – free not only of default risk but also largely of
price risk attributable to interest rate volatility
 The Inverse Relationship Between Bond Prices and Yields

*Note convexity of the price curve.

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 Bond Prices at Different Interest Rates

14-21