Lecture 1

Introduction to Bond
Pricing

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

What is a 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 are often expressed as a
fraction of the FV, e.g. 5 %. We call this the coupon rate (C).
Lets denote the actual coupon, e.g. $5, with ct, where t is the
period in which we get the coupon.
bond fundamentals

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
100

bond fundamentals

Miscellaneous
Default risk
That somebody promises to pay you some money doesnt
necessarily mean they will
The risk that you will be unable to collect your cash flows
is called default risk
This is very important in practice, but we will generally
ignore it in this course

Other frequent assumptions

No transaction costs
Constant interest rates
Complete markets
These are all true within our model
Compare this to the assumption of vacuum in classical mechanics
bond fundamentals

Two approaches to pricing

Fundamental pricing
Prices are set in a supply-demand equilibrium
The properties of an asset tell us what that price is likely to
be
We will use this approach when pricing stocks later in the
course

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
arbitrage pricing

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
arbitrage pricing

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

arbitrage pricing

Example: Pricing a zero-coupon bond

How would you price the risk-free one-year zerocoupon bond below?
Bond A
-P?

100

You may already know how to discount the future

cash-flow with some appropriate discount rate, y, to
get the present value
Assuming that r = 10% youd get
100
100
PA

90.9
1 y 1.10

What is the economic logic behind this?

arbitrage pricing

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
Lets say theres 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
1.1
arbitrage pricing

10

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

We buy the cheap instrument and sell the

expensive (in this case the synthetic) instrument
Selling a bank deposit means borrowing the money
In the discussion of arbitrage pricing, lots of time we
need to adopt Short selling (or shorting) strategies
on instruments (i.e., selling securities you dont hold)

arbitrage pricing

11

Pricing a zero-coupon bond:

Cash flows of arbitraging strategy
Today we borrow $90.9 and buy the bond for
$80.9. We are left with $10.
In one year the bond pays us $100 which is
exactly enough to repay the loan. We have zero
net cash flow.
Our free $10 is an arbitrage profit and the
entire scheme is an arbitrage trade

arbitrage pricing

12

Arbitrage pricing:
how arbitrage affects prices?
In practice smart people will identify arbitrage
opportunities and trade on them
This will increase the demand for the bond and
raise its price until no further arbitrage trades
are possible, i.e. until prices are in equilibrium
In this course we are interested in finding those
equilibria, e.g. arbitrage-free prices
We can not say whether it was the bond price or
the banks interest rate that was wrong
We can only say (and only care) if the prices are
internally consistent
arbitrage pricing

13

Arbitrage pricing: general case

-P

c1

c2

ct

cT
FV

Strategy: Replicate the entire CF-stream we want

to price
For there to be no arbitrage the price of the CFstream must be the same as the price of the
replication

arbitrage pricing

14

Arbitrage pricing: general case (Cont.)

The bond is just a combination of future cash flows
Replicate each cash flow: for example, $5 in year 3,
by depositing a specific amount of money in the
bank which will give you $5 in 3 years
Together, all deposits (T deposits for T cash flows)
will form a replicating portfolio
Note that the interest rate we get for each deposit
may be different from each other (i.e., interest rate
for 1-year deposit may differ from 2-year one).
To indicate the maturity of an interest rate we typically
use a time index: yt

arbitrage pricing

15

Arbitrage pricing: general case (Cont.)

Replicating a cash flow of ct at time t
Today, deposit Mt such that Mt(1 + yt)t = ct
Find that Mt = ct /(1 + yt)t

Replicating the cash flow at maturity, time T

Today, deposit MT such that MT(1 + yT)T = FV + cT
Find that MT = (FV + cT)/(1 + yT)T

Our complete strategy costs which should

equal to price
P = M1 + M2 + + Mt + + MT = c1 /(1 + y1)1 + c2 /(1 +
y2)2 + + ct /(1 + yt)t + + (FV + cT)/(1 + yT)T

arbitrage pricing

16

Arbitrage pricing and discounting

We say that P is the present value, PV, of the
future cash flows
This process of calculating the PV of future CFs
is called discounting
The market determines the appropriate interest rates
for all future horizons, yt
The price of a bond (or indeed any financial asset) is
the sum of the present values of its future cash flows.
We are typically not explicit with the entire arbitrage
argument, but you can see the connection from
previous discussions.

arbitrage pricing

17

Bond price and yield to maturity

Examples of bond price quotes
http://www.asx.com.au/asx/markets/interestRateSec
urityPrices.do?type=GOVERNMENT_BOND

Yield

18

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
Appropriate discount rates, for example, yt, are
determined by the market, i.e., essentially by the
supply and demand of investments producing cash
flows in year t (with identical risks as those from this
bond).

Yield

19

Pricing formula and yield-to-maturity (cont.)

Assuming constant interest rates (discounting rates):
P = c1 /(1 + y)1 + c2 /(1 + y)2 + + ct /(1 + y)t + + cT/(1 + y)T +
FV/(1 + y)T
Note that in practice interest rates are not constant
Instead we take P as given and define y as whatever interest rate
satisfies the equation above. Expressed on an annual basis, we call this
interest rate the yield-to-maturity (YTM, although we often just
denote it y).
Hence YTM essentially summarizes all future interest rates
determining the bond price. And each bond has its own YTM.

If we further assume annual coupons are equal (as in

most bonds),
then

c
1
FV
1

y
1 y T 1 y T

Dont worry about this formulae. At most I will test up to T=3, and you
can easily do the calculation with the general formulae above.
Yield

20

YTM and bond prices

This graph shows the price of a 30-year bond
with a FV of $100 and a coupon rate of 10 % for
different YTMs

350
300
250
200
Price

150
100
50
0
0%

5%

10%

15%

20%

25%

YT M

Yield

21

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

The price is less sensitive to changes in the YTM

when the YTM is high

Yield

22

YTM and realized holding-period return

YTM does not necessarily (actually not in most
cases) equal to realized holding period returns.
Realized bond returns over a year t
Rt = (Pt+ct)/Pt-1 1, or Pt-1*(1+ Rt) = Pt+ct
Prices at ending of t (Pt) or t-1 (Pt-1) are determined as
the present value of future cash flows i.e.,
discounting future cash flows with YTM at the
respective time
And YTM could (and will) change over time
(depending on the market interest rates for all future
horizons at each time).

Yield

23

Realized compound yield

Bond A
Bond B

1
c

c
FVA
2
c
FVB

Suppose that we are interested in comparing the

yields of the two bonds above which have the
same YTM
For a given investment horizon (like 2-year),
cash flows from investing in two bonds will
differ, since bond B pays a coupon at time 1
That coupon will have to be reinvested to make
the cash flows at the end of time 2 comparable
Yield

24

Realized compound yield (cont.)

Realized compound yield
Collect all cash flows at the maturity of the bond
Solve for the annualized return by dividing by the price

Example
Assuming the following bond parameters: $100 face value, 2 years of
time to maturity, $10 annual coupons, 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% in year 2
The resulting (aggregate) cash flow at time 2 would be CF 2=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.

Yield

25

An alternative interpretation of the 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)
Yield

26