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FINS2624 WEEK 2: y Bond Prices

The document discusses the term structure of interest rates and yield curves. It explains that: 1) Long-term bonds typically have higher yields than short-term bonds, forming an upward sloping yield curve. The yield curve plots yields against time to maturity. 2) Bond prices can be determined by discounting their cash flows using the yield curve's spot rates. If a bond is mispriced, arbitrage is possible by constructing a synthetic bond from other securities. 3) The yield curve reflects the market's expectations of future short-term interest rates. However, reinvestment risk exists because future spot rates are unknown, affecting holding period returns.

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Wahaaj Rana
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64 views5 pages

FINS2624 WEEK 2: y Bond Prices

The document discusses the term structure of interest rates and yield curves. It explains that: 1) Long-term bonds typically have higher yields than short-term bonds, forming an upward sloping yield curve. The yield curve plots yields against time to maturity. 2) Bond prices can be determined by discounting their cash flows using the yield curve's spot rates. If a bond is mispriced, arbitrage is possible by constructing a synthetic bond from other securities. 3) The yield curve reflects the market's expectations of future short-term interest rates. However, reinvestment risk exists because future spot rates are unknown, affecting holding period returns.

Uploaded by

Wahaaj Rana
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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FINS2624 WEEK 2

CHAPTER 15 – THE TERM STRUCTURE OF INTEREST RATES

[42] The Yield Curve

 Bonds of different maturities typically sell at different YTMs


o Long term bonds sold at higher yields than short term bonds
 Yield curve: plot of yield to maturity as a function of time to maturity
o Can vary widely
o A plot of all the t spot rates (denoted 0yt)

Bond prices

 Treasury stripping suggests exactly how to value a coupon bond


 If each cash flow can be sold off as a separate security, then value of the whole bond should be the
same as the value of its cash flows bought piece by piece in the STRIPS market
 If not – arbitrage possible
o Bond stripping: if bond selling for less than amount at which sum of its parts could be sold
 Buy bond, strip it into standalone zero coupon securities, sell off stripped cash
flows, and profit by price difference
o Bond reconstitution: bond selling for more than sum of the values of its individual cash
flows
 Buy individual zero coupon securities in STRIPS market, reconstitute cash flows into
coupon bond, and sell whole bond for more than cost of the pieces
 Pure yield curve: curve for stripped, or zero-coupon, Treasuries
 On the run yield curve: plot of yield as function of maturity for recently issued coupon bonds
selling at or near par value

[45] How to determine term structure

Yield Curve under Certainty

 Spot rate: YTM on zero coupon bonds – rate prevailing today for a time period corresponding to
the zero’s maturity
o Appropriate discount rates for pricing (risk-free) future cash flows
 Short rate: interest rate for given interval available at different points in time
 Yield or spot rate on a long term bond reflects the path of short rates anticipated by the market
over the life of the bond
o At least in part, the yield curve reflects the market’s assessments of coming interest rates
 Multiyear cumulative returns on all competing bonds ought to be equal

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Finding implied spot rate:

(1) From zero coupon bonds:

(2) From bonds paying coupons – bootstrapping


e.g. for a two year bond, pricing equation is…

First find r1 from a one year zero coupon bond:

Then substitute into equation for P2;0:

Calculating arbitrage trades

Example: suppose that the following bonds trade in the market

Back out the implied term structure from the pricing equations of bonds A and B

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Use the term structure to calculate the arbitrage free (or implied) price of bond C

Bond C trades for less than the arbitrage free price – there is an arbitrage opportunity

 Construct a synthetic version of Bond C from bonds A and B


 Buy underpriced real bond and sell overpriced synthetic bond

(1) Replicate CFs of the C bond

(2) Replicate first CF (10)


a. Each A bond gives CF1 = 100
b. The synthetic bond contains XA A-bonds, so that XA satisfies:

(3) Replicate second CF (110)

(4) Calculate the CFs

This makes a riskless profit at t=0. When doing so, the supply and demand our trades create will
push bond prices to their arbitrage free values

Reinvestment risk

 Cashflows in future will be unknown as we cannot know the future spot rates valid for time periods
in the future

Example: I hold a bond with an investment horizon of two years. We must reinvest the coupon bond at t=1
to get all cash flows at t=2

If spot rate valid at time 1 for an investment maturing at time 2 is denoted by 1y2, our cash flows at t=2 will
be:

CF2 = FV + c + c(1 + 1y2)

• Since 1y2 is unknown at t = 0, so is CF2

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Holding period returns

 Holding period returns will be the same, even if bonds sell at higher YTMs than others
 See [47-8]
 Now, as total CF at t=2 is unknown due to reinvestment risk, holding period return is denoted:

Forward rates

 Def’n: interest rates for investments we agree on today but that take place in the future
 Notation: forward rate (determined today) for an investment that starts at time s and ends at time
t is denoted sft
 In the absence of arbitrage opportunities, the term structure determines all forward rates

Determining forward rates

Example: we want to determine the forward rate between year 2 and 3, 2f3

Cash flow consequences of investing $1 at this rate:

(1) To get negative CF of $1 at t=2

Borrow

(2) Calculate repayment


a. At t = 2 we must repay this with interest

(3) Calculate CF at t=3


a. If we invest the money we borrowed for three years we achieve a CF at t = 3 of

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(4) Equate CFs at t=3

Refer to [SP8-9] for implied forward rates

Interest rate uncertainty and forward rates

Liquidity risk

 Arises as investment horizon is not matched to cash flows

Example: suppose investor has an investment horizon of one year. If they hold a coupon bond that matures
a t = 2, they must sell it at t = 1 to achieve their period 1 cash flow

 Bond price at t=1: P1 = (c + FV)/(1 + 1y2)


 CF at t=1: CF1 = c + P1
 HPR is:

Since 1y2 is unknown at t = 0, so is P1 and HPR

Example: suppose that most investors have short-term horizons and therefore are willing to hold a 2 year
bond only if its price falls from 943.40 to 881.83. (Originally had 1-year interest rate of 6%, with a HPR of
5%). At the price wanted, the expected HPR on the 2 year bond is 7% (943.40/881.83=1.07) Risk premium
of the 2 year bond is therefore 2%, as it offers an expected rate of return of 7% v 5% risk free return on the
1 year bond.

 Forward rate 1f2 no longer equals expected short rate 1y2.


 YTM on 2 yr zeros selling at 881.83 = 6.49m and:

(1 + 𝑦2 )2 1.06492
1 + 𝑓2 = = = 1.08
1 + 𝑦1 1.05

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