FINS2624 Lecture 1: Introduction to Bond Pricing and the Term Structure of Interest Rates I

Flashcards covering bond characteristics, arbitrage pricing, yield to maturity, return measures, and the term structure of interest rates.

Bond

A certificate specifying a debt obligation between an Issuer (borrower) and Bondholders (lenders).

Issuers

Role of government agencies and corporations in bond markets

Bondholders

Role of Institutional investors and hedge funds.

Indenture

The contract between the issuer and the bondholders describing the terms, conditions, and protections, if any.

Coupon Payments

A series of smaller cash flows (interest payments) given to bondholders regularly up to and including maturity.

Principal

Repaid at maturity.

Default Risk

The risk that the issuer will not repay their debt obligations.

Term (T)

The period of time to maturity of the bond (i.e., when the bond pays its last cash flow).

Face Value (FV)

The principal or loan amount of the bond, typically repaid in full as one large cash flow at maturity; Also called par value.

Coupon rate (C)

The total annual "interest" payments of the bond.

Coupon frequency

The number of times per annum the coupon is paid.

Yield to Maturity (YTM)

The discount rate on the bond’s principal and coupon cash flows that gives the actual, market price.

Arbitrage

A set of trades that either has a positive and risk-free cash flow today with no net outlay (i.e., zero cash flow) at all points in the future, or requires no net capital outlay today and generates positive but risk-free cash flows in the future.

Law of One Price

Two assets with identical cash flows should have the same price in equilibrium.

Arbitrage Pricing

Building a replicating portfolio of assets (also called a synthetic asset) with known prices that has the exact same future cash flows as those of the asset we want to price.

Replicating Portfolio

A collection of assets with known prices that exactly mimic the cash flows of the asset we want to price.

Bond Price

The sum of the present value (PV) of its future cash flows.

Discounting

The process of calculating the PV of future CFs.

Yield to Maturity (YTM)

The process of calculating the PV of future CFs.

Bond Types Based on Price and YTM

Premium Bond: P > FV (C > YTM), Par Bond: P = FV (C = YTM), Discount Bond: P < FV (C < YTM)

Realized Compound Yield Derivation

Reinvest all interim cash flows at the market interest rates available at different horizons until the end of the holding period, Calculate the total bond proceeds as the value of all cash flow at the end of the holding period, Calculate the holding period return (HPR) by dividing Total Bond Proceeds by the original bond price P0, Annualise the return to get the realised compound yield

Term Structure of Interest Rates

Describes how interest rates are expected to vary over different investment horizons.

Yield Curve

Displays the relationship between yield and maturity.

Zero Coupon Bond

A bond that makes no coupon payments, making a single payment of principal at maturity.

Bond Stripping

The process of repacking each coupon and principal payment from a coupon bond as a new, separate zero coupon bond.

Pure Yield Curve

Derived from zero-coupon or stripped bond prices.

On-the-run Yield Curve

Derived from recently issued (on-the-run) coupon bonds selling at or near par.

Spot Rates

The interest rate today (at time 0) for a t-period zero coupon bond; specifically refers to zero-coupon bonds and, as a result, may differ from the YTM (y) of a t-period coupon bond.