BondYieldtoMaturity

Wehaveexpressedthepriceofanoptionfree
bondasafunctionofthebondsyieldto
maturity:
n

1
2
P =
+
y i1+q
y n1+q
i=1 (1+ 2 )
(1+ 2 )
whereq =

days from settlement to next coupon date

days in current coupon period

BondYieldtoMaturity
Differentbondshavedifferentyields
Riskdifferentials(qualityspread)
Sectorspreads(e.g.industrialsv.utilities)
Optionality
Taxdifferences
Termdifferences

Benchmark:Treasuries
RiskybondspricedataspreadtoTreasuries

YieldCurve
Agraphofbondyieldstomaturitybytimeto
maturityiscalledayieldcurve.
7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo

6mo

1yr

2yr

3yr

5yr

10yr

30yr

YieldCurve
Typically,theyieldcurveisupwardsloping
Yieldtomaturityriseswithtermtomaturity
Theexcessofthelongyieldovertheshortyieldiscalleda
termpremium
7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo

6mo

1yr

2yr

3yr

5yr

10yr

30yr

YieldCurve
Othershapesarealsopossible,however
Inverted:Commonlyassociatedwithrecessions
Flat
15.00%
13.00%
11.00%
9.00%
7.00%
5.00%
3.00%
1.00%
-1.00%

3mo

6mo

1yr

2yr

3yr

5yr

10yr

30yr

YieldCurve
Itusedtobethatmostfixedincomesecurities
werepricedataspreadrelativetotheTreasury
yieldcurve.
Forexample:
Iftheyieldtomaturityonthe10yearTreasury
bondwas7%,thena10yearBaacorporatebond
wouldbepricedtoyield7%plustheBaacredit
spread.
Theproblemwiththisapproachisthatitignores
differencesindurationandconvexitythatmaybe
priced.Canyouseewhy?

YieldCurve
Heresyieldcurvedataforontherun
Treasuriesofvariousmaturities:
Noticethe
rangeof
coupons.

Coupon

Term (yrs)

Yield

8.50%

Thesebonds
havevery
differentcash
flowpatterns.

1/2

Price

5.10%

$101.66

7.38%

5.49%

$101.81

9.00%

1 1/2

5.63%

$104.78

8.88%

5.81%

$105.72

6.75%

2 1/2

5.86%

$102.03

7.75%

5.93%

$104.94

6.25%

3 1/2

6.03%

$100.69

5.63%

6.09%

6.50%

4 1/2

6.10%

$101.56

7.50%

6.16%

$105.69

$98.38

ABetterApproach
Toavoidtheproblemsofcomparabilitycaused
bydifferingcashflowpatternsamongonthe
runTreasuries,wecanrealizethateachcoupon
bondisreallyapackageofsinglepayment
bonds.
Forexample,a2year10%couponbondis
reallyapackageoffivesinglepaymentbonds:
fourforthesemiannualcouponpaymentsand
onefortherepaymentofthecorpus.

Zeroes
Asinglepaymentbondiscalledazero.
Acouponbondcanbethoughtofasapackage
ofzeroes,
oneforeachofthecouponpaymentsand
oneforthecorpus.

Inprinciple,anycouponbondcouldbe
strippedorunbundledintoitsconstituent
zeroes.
USTreasurySTRIPSareunbundledcouponbonds.

SpotYields
Aspotyieldisthecurrentyieldtomaturity
onazerocouponbond.
Forexample,the1yearspotyieldistheyieldto
maturityona1yearzero.

Theprice(perdollarofcorpus)ofannyear
zeroisrelatedtothenyearspotratebythe
formula:
1

P =
2n
in
1+ 2

0 n

SpotYields
Forexample,ifthe31/2yearspotyieldis
6.05%,thentheprice(perdollarofcorpus)of
the31/2yearzerois:
1
1
0P3.5 =
2*3.5 =
7 =.811
(1.03025
)
(1+.06052)

SpotYields
Alternatively,wecanexpressthenyearspot
yieldasafunctionofthepriceofannyear
zero:
1

1 2n

in =2
P 1

0 n

SpotYields
Forexample,ifa4yearzeroispricedat$.79
perdollaroffacevalue,thenthe4yearspot
rateis:
1
1

1 2*4
8

1
1 =2(1.030591) =6.12%

1 =2
i4 =2

.79

0 4

SpotYields
Term (yrs)
1/2
1
1 1/2
2
2 1/2
3
3 1/2
4
4 1/2
5

Spot Yield
5.10%
5.49%
5.64%
5.82%
5.88%
5.95%
6.05%
6.12%
6.12%
6.19%

Price of zero
$0.98
$0.95
$0.92
$0.89
$0.87
$0.84
$0.81
$0.79
$0.76
$0.74

=
5 =.87
.0588
1+ 1 2
1 9
i4.5 =2
1 =6.12%
.76

0 2.5

PriceofaCouponBond
Inprinciple,thepriceofannyearcouponbond
oughttobeequaltothetotalvalueofallits
constituentzeroes:
c

2n

2n

1
2
2
P =
s+
2n =
s +
2n

i
s=1
s=1
s
n
1+
1+
2
1+
1+ 2
2 2
2

Pricedusingyieldtomaturity

Pricedusingspotyields

PriceofaCouponBond
Forexample:
5-year 7.5% coupon bond

1/2

Spot Yield

Price of zero

Cash flow

Value

5.10%

$0.98

$0.0375

$0.0366

5.49%

$0.95

$0.0375

$0.0355

1 1/2

5.64%

$0.92

$0.0375

$0.0345

5.82%

$0.89

$0.0375

$0.0334

2 1/2

5.88%

$0.87

$0.0375

$0.0324

5.95%

$0.84

$0.0375

$0.0315

3 1/2

6.05%

$0.81

$0.0375

$0.0304

6.12%

$0.79

$0.0375

$0.0295

4 1/2

6.12%

$0.76

$0.0375

$0.0286

6.19%

$0.74

$1.0375

$0.7647

$1.0571

Thisbondactuallytradedatapriceof$1.0569orayield
tomaturityof6.16%

STRIPS
Gotospreadsheetforcomparisonofstripping
andreconstituting2different10yrbonds.

TermStructure
Thetermstructureofinterestratesisthepattern
ofspotratesovertherangeofmaturities.
Aflattermstructuremeansthatspotyieldsare
equalatallmaturities.
Anormaltermstructureslopesupward
Aninvertedtermstructureslopesdownward

Modernpricingpracticeistoregardanybond
asapackageofzerosandpricethepackage
usingspreadsrelativetothetermstructure.

Bootstrapping
Wecanderivethetheoreticaltermstructure
fromtheyieldcurveusingaprocedureknown
asbootstrapping.
Heresyieldcurveinformation
Coupon

Term (yrs)

Yield

8.50%

1/2

Price

5.10%

$101.66

7.38%

5.49%

$101.81

9.00%

1 1/2

5.63%

$104.78

8.88%

5.81%

$105.72

6.75%

2 1/2

5.86%

$102.03

7.75%

5.93%

$104.94

6.25%

3 1/2

6.03%

$100.69

5.63%

6.09%

6.50%

4 1/2

6.10%

$101.56

7.50%

6.16%

$105.69

$98.38

Bootstrapping
Thefirstbondhas1/2yeartorun
Itisasinglepaymentbondthatwillpay
$1.0425perdollaroffacevalueatmaturity.
Itspriceis$1.0166perdollaroffacevalue.
Thereforethe1/2yearspotrateis
1.04251
i1/2 =2
1 =2(.0255
) =5.10%

1.0166

Bootstrapping
Giventhe1/2yearspotrate,wecandetermine
thepriceofthe1/2yearzero:
P

0 1/2

1
2 1/ 2)

1+i1/ 2 (

1
=
=.9751
.0510
1+

Bootstrapping
Foreachdollaroffacevalue,the1yearbond
willpay$.03675in6monthsand$1.03675in
oneyear.
Itsprice($1.0181perdollaroffacevalue)
shouldequal
$0.03675 $1.03675
$1.0181=
1 +
2
i1/ 2
i1
1+
1+

2
2

Bootstrapping
Butsincethe6monthsspotrateis5.10%,
$0.03675 $1.03675
$1.0181=
1+
2
.0510
i1
1+
1+

2
2

Whichwecansolveforthe1yearspotrateas
1.03675 1/2
i1 =2
1 =5.49%

1.0181.03596

Bootstrapping
Or,wecouldwrite
$0.03675 $1.03675
$1.0181=
1 +
2
i1/2
i1
1+
1+

2
2
$1.0181=$0.03675
*0 P1/ 2 +$1.03675
*0 P1

as

=$0.3675
(.9751
) +$1.03675
*0 P1
=$0.03596+$1.03675
*0 P1

solvefor0P1andtheni1

Bootstrapping
Youcontinuethisprocesstocompletethe
theoreticaltermstructure
Coupon

8.50%

Maturity

Yield

0.5

7.38%

9.00%

1.5

8.88%

6.75%

2.5

7.75%

6.25%

3.5

5.63%

6.50%

7.50%

4.5

Price

Zero Price

Spot Yield

5.10%

$101.66

$97.51

5.10%

5.49%

$101.81

$94.73

5.49%

5.63%

$104.78

$92.00

5.64%

5.81%

$105.72

$89.16

5.82%

5.86%

$102.03

$86.51

5.88%

5.93%

$104.94

$83.88

5.95%

6.03%

$100.69

$81.16

6.05%

$78.58

6.12%

6.09%

$98.38

6.10%

$101.56

$76.23

6.12%

6.16%

$105.69

$73.71

6.19%

ForwardRates
Aforwardrateofinterestisayieldquotednow
onazerocouponbondtobedeliveredinthe
future.
Forexample,a2yearrate1yearforwardisthe
yieldquotedtodayona2yearzerostartingone
yearfromnowandmaturing3yearsfromnow.

ForwardRates
Forwardratesareembeddedintheterm
structure.
Supposeyouownazerothatmaturesin1year
andyields6%.
Interestcouldaccumulateatthesamerateoverthe
entireyearor
Itcouldaccumulateatonerateforthefirsthalfyear
andatanotherrateforthesecondhalfyearsuchthat
theaverageis6%.

ForwardRates

1/2

ForwardRates
Algebraically,ifyouinvest0P1at6%for1year,
andinterestaccumulatesatthesamerate
throughouttheyear,thenattheendofahalf
yearyouwillhave
Andattheendofa
yearyouwillhave

.06
0P1 1+

2
2

.06
0P1 1+

ForwardRates
Alternatively,ifyouinvest0P1atsay4%for1/2
year,andthenreinvesttheproceedsatanother
rate,say1r1,thenattheendofahalfyearyou
willhave
Andattheendofa
yearyouwillhave

.04
0P1 1+

2
.04 1r1
1+
0P1 1+

2
2

ForwardRates
Thesetwoaccumulationpathswillbothresult
ina6%yieldfortheyearif
2

.06 .04 1r1

1+
= 1+
1+

2
2
2

Thatis,if

.06
1+
(
2)

r
=2

1
11

.04
(1+ 2)

ForwardRates
Generally

P
0 s
r
=2

s 1

2
0 Ps+12