Study Session 16 Fixed Income: Basic Concepts: Reading 52

1
Study Session 16
Fixed Income: Basic Concepts

Reading 52
Introduction to Fixed-Income Valuation

Learning Outcomes for Study Session 16 – Reading 52:
Reading 52: Introduction to Fixed-Income Valuation

LOS 52.a: Calculate a bond's price given a market discount rate.

LOS 52.b: Identify the relationships among a bond's price, coupon rate, maturity, and market discount rate (yield-
to-maturity).

LOS 52.c: Define spot rates and calculate the price of a bond using spot rates.

LOS 52.d: Describe and calculate the flat price, accrued interest, and the full price of a bond.

LOS 52.e: Describe matrix pricing.

LOS 52.f: Calculate and interpret yield measures for fixed-rate bonds, floating-rate notes, and money market
instruments.

LOS 52.g: Define and compare the spot curve, yield curve on coupon bonds, par curve, and forward curve.

LOS 52.h: Define forward rates and calculate spot rates from forward rates, forward rates from spot rates, and
the price of a bond using forward rates.

LOS 52.i: Compare, calculate, and interpret yield spread measures.

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Reading 52 - Introduction to Fixed-Income Valuation
2
Study Session 16
Fixed Income: Basic Concepts

Reading 52
Introduction to Fixed-Income Valuation

LOS 52.a: Calculate a bond's price given a market discount rate.

The fundamental principles of bond valuation

The fundamental principle of valuation is that the value of a fixed income security is equal to the present
value of the security’s expected cash flows.

The valuation of a fixed income security involves the following four steps:

1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash
flows.
3. Calculate the present value of the expected cash flows found in step 1 using the interest rate or
interest rates determined in step 2.
4. Sum the present values together to determine the valuation.

1. Estimate the expected cash flows

When we purchase a security, we lay out cash (the purchase price). As we hold the security, we expect
to receive the cash back in the form of dividends in order to provide us with a return on our investment.
We also expect to receive our initial investment back in the form of cash.
A cash flow is simply each of the cash flows that are expected to be received in the future from that
investment. In the case of a fixed income security the cash flows consist of:

• Interest
• Repayment of the principal

There are times when investors find it difficult to estimate the cash flows, such as when:

a. The issuer or the investor has the option to change the date of the repayment of the principal
b. The coupon payment is reset at certain times based on a formula that depends on some value or
values for reference rates, prices, and exchange rates
c. The investor has the choice to convert the bond into common stock

Examples of (a) are callable bonds, putable bonds, mortgage-backed securities and asset-backed
securities
Examples of (b) are floating-rate securities
Examples of (c) are convertible bonds and exchangeable bonds


3
2. Determining the appropriate rate or rates at which to discount a bond’s cash flows

Once we have estimated the future cash flows, in order to determine the bond’s present value we need
to discount these cash flows back to the valuation date. Thus we need to determine an interest rate or
interest rates to discount these cash flows back.

The lowest interest rate the investor should earn on his investment is the yield that he could earn on a
risk-free investment such as a U.S. government issued security, with a similar maturity.

The additional interest rate over and above the risk-free interest rate is what the investor requires for
investing in a non-risk-free investment.

As you know the yield curve is not the same over different maturities. Thus, for each cash flow that has a
different maturity, we need to apply a different interest rate to that specific cash flow. Thus each of the
coupon payments and the maturity value will have an interest rate specific to their specific maturity. It
is this interest rate that should be used to discount the future cash flow back to the present.

We will use the yield to maturity as the appropriate discount rate to discount the bond’s cash flows.

We will discuss how we arrive at these interest rates in later lessons. For the time being, we will provide
you with the interest rate associated with each cash flow.

3. Compute the value of a bond by discounting the expected cash flows

In order to determine the present value of the cash flows, we need to discount the cash flows (from
point 1 above) using the interest rates determined in point 2 above.

The present value of a cash flow that will be received in the future is equal to the amount of money that
must be invested today to generate that future cash flow.

The present value of a cash flow is dependent on:

• Time from valuation date to the cash flow date (as the cash flow is discounted over this period), as
well as
• The interest rate (as this is the rate that is used to discount the future cash flow).

You may also encounter the interest rate being referred to as the discount rate or the yield to
maturity

A present value for each expected cash flow is calculated. All of these present values are then summed in
order to determine the value of the security.

The formula to calculate the present value of an expected cash flow t years from now using a discount
rate of i is.

./012,13 2456 789: ;< 01=;93>
Present value, = (@A;)>

The value of an instrument is then the sum of the present value of all the expected cash flows. Assuming
there are N expected cash flows the formula is as follows:
Value = present value 1 + present value 2 + … + present value N

4
To illustrate this let’s consider an example:

Example: Calculating the value of a bond

A bond has a coupon rate of 5% and a maturity value of $100 in three years’ time. Assume the bond pays
interest annually and a discount rate of 8% should be used to calculate the present value of each cash
flow. Calculate the value of the bond.

As you can see we are using a flat interest rate for all cash flows. We will consider other examples where
the interest rate differs for each cash flow later on.

Solution:

Step 1: Identify the appropriate formula

Value of bond = present value 1 + present value 2 + … + present value N

The bond will mature in three years’ time, and it pays interest annually. Thus there will be cash flows on
three dates.
The formula is thus = present value 1 + present value 2 + present value 3

./012,13 C456 789:
The present value formula = (@A@)>

Step 2: Identify the given variables

The cash flow for the bond is:

Year Cash Flow
1 $5
2 $5
3 $105

In year 1 and 2 there are only interest payments, but in year 3 there is an interest payment of $5 and the
maturity of the bond of $100.

i = 8% for each cash flow

Step 3: Solve for the unknown

The present value of each cash flow using our formula above is:
5
Year 1: present value 1 = = 4.6296
(1.08)1

5
(1.08) 2

105
(1.08) 3

5
The present value of the bond using our formula is:

= 4.6296 + 4.2867+ 83.3524
= 92.2687

How to calculate this using your calculator

N = 3
PMNT = -5
Future value = -100
Interest rate = 8
Compute PV = 92.27

What do each of the terms mean?

N = Number of periods that the bond is in existence for
PMNT = The coupon payment that is made every period
Future value = The par value or face value of the bond at maturity
Interest rate = The discount rate or yield on the bond
Present value = The price of the bond

How the value of a bond changes if the discount rate increases or decreases or the length of time
changes

There are three important points that you must remember regarding discounting and the discount rate
and the effect on the bond’s value:

1. For a given discount rate, the greater the length of time from the valuation date to the date of the
cash flow, the lower the present value. An example of this would be a cash flow of $100 in 1 years’
time and a cash flow of $100 in 10 years’ time. The present value of the cash flow in 1 years’ time
assuming a discount rate of 5% is $95.23 whereas the present value of the cash flow in 10 years’
time is $61.3 assuming the same 5% discount rate. As you can see the longer the length of time to
the cash flow, the lower the present value.
2. The higher the discount rate, the lower the bond’s value.
3. The lower the discount rate, the higher the bond’s value.

Example: Value of a bond at different maturities

A bond only has one cash flow, a maturity value of $100 in two years’ time. Assume that the discount
rate is a constant 5%. Calculate the value of the bond for a maturity in two years’ time as well as the
value of the bond if the maturity is in four years’ time.

The value of a bond with a maturity value of $100 in two years’ time.

2 [N], -0 [PMT], -100 [FV], 5 [I/Y], [CPT] [PV] = 90.70

The value of a bond with a maturity value of $100 in four years’ time.

4 [N], -0 [PMT], -100 [FV], 5 [I/Y], [CPT] [PV] = 82.27

Thus the value of the bond is 90.70 if the maturity is received in two years’ time, but drops to 82.27 if
the maturity is received in four years’ time.

Thus, for a given discount rate, the further away from the date, the lower its’ present value.


6
Example: Value of the bond using a required rate of return

A bond has a coupon rate of 5% and a maturity value of $100 in three years’ time. Assume the bond pays
interest annually. Calculate the value of the bond using a required rate of return of 2%, 5%, and 8%.

At 2% = 3 [N], -5 [PMT], -100 [FV], 2 [I/Y], [CPT] [PV] = 108.65
At 5% = 3 [N], -5 [PMT], -100 [FV], 5 [I/Y], [CPT] [PV] = 100
At 8% = 3 [N], -5 [PMT], -100 [FV], 8 [I/Y], [CPT] [PV] = 92.27

The minus sign means that there will be a cash outflow in order to receive the interest payments and
the maturity payment. The value of the bond will thus be:

Discount rate Value

2% 108.65
5% 100
8% 92.27

The differences in value are purely due to the discount or interest rates being different.

The shape of the graph showing how the discount rate affects price is as follows:

Bond
value

Discount rate

From the graph you can see:

discount rate = ¯bond value

¯discount rate = bond value

The shape of the curve is referred to as convex which we will look at in more detail later on.

LOS 52.b: Identify the relationships among a bond's price, coupon rate, maturity, and market
discount rate (yield-to-maturity).

Price vs yield-to-maturity

The yield to maturity is the interest rate that will make the present value of the bond’s cash flows
equal its market price + accrued interest.
Another term for this is the Internal rate of return (IRR).

As long as we have the price of the bond and its’ cash flows we can then work out the yield to maturity
on this bond.

7
Example: Calculating market yield

Assume the following details:

• A 10-year Treasury bond
• Par value of the bond = $100
• An 8% coupon
• Coupon payments made semi-annually = $4 per period
• Price of the bond = $93.4960
• Market yield = ?

The following cash flow profile is applicable to the bond:

-93.49 4.00 104.00

To T1-19 T20

Calculate the IRR:

Cash flow 0 = -93.4960
Cash flow 1-19 = 4.00
Cash flow 20 = 104

IRR = 4.500%

This IRR is for every 6 months.
Therefore per annum = 4.500% X 2
Yield to maturity = 9.00%

The market convention is simply to multiply the IRR that was obtained for a six-monthly payment by
two.

Bond relationships

The following relationships exist between the price of a bond and its yield:

1) There is an inverse relationship between bond prices and yields

When interest rates rise Bond price drop
When interest rates fall Bond prices rise

Reason for the inverse relationship between changes in interest rates and price

Example: Valuing a bond

Assume that a 20-year bond with a 6% coupon rate is selling at par (i.e. at a yield of 6%). This means
that the investor is willing to accept a 6% coupon rate for purchasing the bond.
How would we value this bond?


8
By using simple time value of money techniques, we would value the bond as follows:

Present value = ?
Future value = -100
Interest rate (yield) = 6%
Number of years = 20
Payment = -6 (100 X 6% the coupon rate)

Compute the Present value with a financial calculator:

Present value = 100
This present value is equal to the PRICE of the bond.

Drop in yields

Assume that the yield on similar bonds drops to 5.5% - what does this do to the price of the bond?

Present value = ?
Future value = -100
Interest rate (yield) = 5.5%
Number of years = 20
Payment = -6 (100 X 6% the coupon rate)

Compute the Present value with a financial calculator:

Present value = 105.9752

This present value is equal to the PRICE of the bond.
As you can see the price of the bond increases with a drop in yields.

Rise in yields

Assume that the yield on similar bonds rises to 6.5% - what does this do to the price of the bond?

Present value = ?
Future value = -100
Interest rate (yield) = 6.5%

Interest rates rise

Based on the above example assume that the day after the investor purchased the bond at 100 with a
coup0n rate of 6% and a yield of 6% then market yields or interest rates moved upwards to 6.5%.

In this market, if a bond issuer wants to issue a bond at par, he will need to offer a coupon rate of 6.5%
(i.e. the market rate) in order to attract investors.
In this same market, if the original buyer of the bond (at a coupon rate of 6%) wishes to sell his bond to
another investor, he will not be able to sell it for 100 since other investors can buy a bond with a coupon
of 6.5% for 100. Therefore in order to sell his bond, the price will need to be less than 100. This is the
reason that when rates increase the value of bonds decreases.

Interest rates fall

Based on the above example assume that the day after the investor purchased the bond at 100 with a
coup0n rate of 6% and a yield of 6% then market yields or interest rates moved downwards to 5.5%.

9
In this market, if a bond issuer wants to issue a bond at par, he will offer a coupon rate of 5.5% (i.e. the
market rate).
In this same market, if the original buyer of the bond (at a coupon rate of 6%) wishes to sell his bond to
another investor, he will now be able to sell it for more than 100 since now other investors can only buy
a bond with a coupon of 5.5% for 100. Therefore in order to sell his bond, the price will be more than
100. This is the reason that when rates decrease the value of bonds increase.

Coupon vs Yield

Type of bond Price of bond Yield vs Coupon YTM vs coupon rate

Premium bond Greater than par Coupon > yield Coupon > YTM
Discount bond Less than par Coupon < yield Coupon < YTM
Par value bond At par Coupon = yield Coupon = YTM

Percentage price moves

For larger changes in the yield the % price change for a given bond is not the same for an increase in the
yield as it would be for a decrease in the yield.

Which direction do prices move in?

For the same change in the yield to maturity, which will affect the price of the bond, the % price
increase in bonds (i.e. decrease in yields) is greater than the % price decrease in bonds (i.e. increase in
yields).

The reason for this is that the relationship between a bond’s price and its yield is not linear but rather
convex. See the illustration below.

Coupon rate

All else being equal, the lower the coupon rate, the more sensitive the price of the bond will be to
changes in the yield.


10
Maturity

All else being equal, the longer the maturity of the bond the more sensitive the price of the bond will be
to changes in the yield.

See the graph below for an illustration of the relationship between bond prices and the yield to
maturity:

Price

D
B

A

E
C

Required Yield
Decrease in required Increase in required
yield yield

Current yield

Price vs. Maturity

How a bond’s value changes as it moves closer to maturity

The changes to a bond’s value over time is as follows:

1. It decreases over time if the bond is selling at a premium (decreases towards par)
2. It increases over time if the bond is selling at a discount (increases towards par)
3. It is unchanged if the bond is selling at par value (it is already at par)

The above relationships assume that the discount rate does not change as we value the bond closer and
closer to par.

At the maturity date, the bond’s value is always equal to its par value. So, over time as the bond moves
toward its maturity date, its price will move to its par value – this is known as “pull to par value.”

Let’s consider our three-year bond that we dealt with above. To illustrate the principle above let’s
consider how the value changes with a required discount rate of 2%, 5%, and 8%.

We have given you the valuation for each of the maturities. If you would like the practice, you can
calculate these values using your calculator.


11
Time to maturity 2% 5% 8%

3 Years 108.65 100 92.27
2.5 Years 107.24 100 93.44
2 Years 105.82 100 94.65
1.5 Years 104.39 100 95.91
1 Year 102.94 100 97.22
0.5 Year 101.48 100 98.59
Maturity 100 100 100

Graphically this looks as follows:
Price decreases over time to par if
Price 108.65 the bond is selling at a premium
of
bond

100

Price increases over time to par if
92.27 the bond is selling at a discount

3 years to Maturity
maturity

From the graph, you can see how the value of the bond moves towards its par value , as the bond gets
closer to maturity.

LOS 52.c: Define spot rates and calculate the price of a bond using spot rates.

Valuation of a bond using different discount rates for each cash flow

Up until now, we have only considered the use of one discount rate, i.e. the yield-to-maturity, to
compute the present value of each cash flow. This is not entirely correct, as interest rates are seldom flat
over a number of different maturities. Thus, it is correct to use a different discount (interest) rate for
each different cash flow date.

The rate that we use is the spot rate. The spot rate is the rate that we would use to discount zero-
coupon bonds and are often referred to as the zero coupon rate.

Let’s look at how we value a security using different discount rates for each cash flow date.

Example: Calculating the present value

A bond has a coupon rate of 5% and a maturity value of $100 in three years’ time. Assume that the
appropriate discount rates are:

Year 1 6.7%
Year 2 7.1%
Year 3 7.5%


12
Step 1:

Identify the appropriate formula

We use the same formula as in the example above.

Value = present value 1 + present value 2 + present value 3

./012,13 C456 789:
The present value formula =
(@A@)>

Step 2:

Identify the given variables

The cash flows for the bond are:

Year Cash Flow
1 $5
2 $5
3 $105

i = Year 1 6.7%
Year 2 7.1%
Year 3 7.5%

Step 3:

Solve for the unknown. The present value of each cash flow is:

D
(@.FGH)I

D
(@.FH@)J

@FD
(@.FHD)K

The present value of the security using our formula is:

= 4.6860 + 4.3590 + 84.5209

= 93.5659

How to calculate this using your calculator

Because of the different interest rates for each cash flow, we cannot calculate the value of the bond like
we did when there was just one interest rate.

In this case we need to value each cash flow separately (using our calculator) and then add them
together as follows:


13
Year 1: 1[n], 5[FV], 0[PMT], 6.7[i], [PV] = 4.686

Year 2: 2[n], 5[FV], 0[PMT], 7.1[i], [PV] = 4.359
Year 3: 3[n], 105[FV], 0[PMT], 7.5[i], [PV] = 84.52

Value = 93.565

LOS 52.d: Describe and calculate the flat price, accrued interest, and the full price of a bond.

Valuing a bond between coupon payments and calculating its dirty price, accrued interest, and
clean price

If you are asked to value a bond between coupon payments, this becomes more difficult. The reason for
this is because the bond seller would have earned interest from the last payment date to the date he
sells the bond, but the next coupon payment gets paid in full to the new bond buyer. Thus, the coupon
payment of the bond after it has been sold will be made up of:

1. Interest earned by the seller
2. Interest earned by the buyer

Interest earned Interest earned
by seller by buyer

Coupon payment Settlement date Coupon payment
date before sale date after sale

The interest earned by the seller from the last coupon payment date to the settlement date is called the
accrued interest. The buyer needs to compensate the seller for this accrued interest, as the seller will
receive the full coupon on the next coupon date.

Full price (dirty price)

The full price is the price taking into account accrued interest (also referred to as the dirty price). It is
this price that the buyer pays the seller.

Clean price (flat price)

This is the price excluding the accrued interest

Clean price = Dirty price – accrued interest

Note:
When you see a bond price quoted it is usually the clean price.

Computing the full price

To compute the full price, we first need to calculate the period between the settlement date and the next
coupon date as follows:

34L5 M1,:11< 51,,81N1<, 34,1 4<3 <1/, 29O09< 04LN1<, 34,1
w periods =
34L5 ;< 29O09< 01=;93

We then change our present value formula to calculate the expected cash flow to be received t periods
from now using a discount rate and i assuming the first coupon payment is w periods from now is:

14

This new formula looks as follows:

./012,13 2456 789: ;< 01=;93>
Present Value t =
(@A;)>PIQR

Example: Calculating full price of a bond

On 1 November 20x2 you decide to sell a bond that will mature on 31 December 20x4. The bond is a
semiannual bond with a coupon of 10%, and the annual discount rate is 8%. The bond’s coupon dates
are 30 June and 31 December each year. The bond uses a 30/360 day count convention. Calculate the
full price of the bond.

Step 1:

Determine how many coupons are left.

There are five coupons left, namely 31 December 20x2, 30 June 20x3, 31 December 20x3, 30 June 20x4,
and 31 December 20x4.

Step 2:

Calculate the w value

34L5 M1,:11< 51,,81N1<, 34,1 4<3 <1/, 29O09< 04LN1<, 34,1
w periods =
34L5 ;< 29O09< 01=;93

If the bond is sold on 1 November, there are 59 days from 1 November until 31 December. (A 30/360
day count convention assumes that there are 30 days in a month and 360 days in a year).

The number of days in the coupon period is 180. (6 months x 30 days)

Thus:

DS
w =
@TF

= 0.3278

i = 4% (8/2) as the coupon payments are semiannual.

Step 3:

Calculate the present value of the cash flows

The present values of the cash flows at an 8% annual discount rate are:

$D
Period 1: present value 1 = = 4.9361
(@.FV)W.KJXY

$D
(@.FV)I.KJXY

$D
(@.FV)J.KJXY

15
$D
(@.FV)K.KJXY

$@FD
(@.FV)Z.KJXY

Thus the full price is 107.24

The good news is that there is a quicker way to calculate the full price of the bond by using your
calculator. We will illustrate this using the same example as before.

Step 1:

Calculate the value of the bond assuming that the sale went through at the beginning of the period, in
other words at the end of June 20x2.

FV = -100
I = 4 (8/2)
PMT = -5
N = 5
PV = 104.45

Step 2:

We now need to adjust the price upwards to reflect the fact that the bond was in fact sold at a later date
(and not at the end of June 20x2, the valuation date). The bond was sold on the 1st of November 20x2,
which was 121 days later.

The full price is calculated as follows:

= 104.45 x (1 + 0.04)121/180
= 104.45 x 1.0267
= 107.24
Computing the accrued interest and the clean price

Computing the accrued interest and the clean price

Full price = clean price + accrued interest.

The formula for the calculation of the accrued interest (AI) is:

AI = semiannual coupon payment x (1 – w)

So, for the 10% coupon bond whose full price we computed, the accrued interest is:

AI = $5 x (1 – 0.3278) = $3.361

The clean price is then = Full price – accrued interest

107.24 - 3.361 = 103.879


16
LOS 52.e: Describe matrix pricing.

What is matrix pricing?

Matrix pricing is a method that is used to estimate the discount rate used to price bonds that are not
actively traded.
Since the bonds are not actively traded, it is difficult to find an appropriate discount rate to use to
discount their cash flows.

Matrix pricing utilizes the discount rates on comparable bonds, which are then interpolated to arrive at
the discount rate for the bond we are looking at.

Example: Calculating yields on bonds

An analyst is trying to estimate the value of an illiquid 5%, 7-year bond that is trading at par.

The following bonds are of similar credit quality to the 7-year bond:

Bond X Bond Y

Credit quality B+ B+
Term to maturity 5 years 9 years
Coupon 4% 6%
Price $97 $103
Par value $100 $100

Step 1:

Calculate the yields on Bond X and Bond Y.

Yield on Bond X:

Present value = 97
Future value = -100
Yield = ?
Number of years = 5
Payment = -4

Compute i = 4.6869%

Yield on Bond X:

Present value = 103
Future value = -100
Yield = ?
Number of years = 9
Payment = -6

Compute i = 5.5672%


17
Step 2:

Interpolate the rate on the 7-year bond, using linear interpolation.

H[D
= 4.6869% + X (5.5672% - 4.6869%)
S[D

= 4.6869% + 0.4402%

= 5.1271%

Step 3:

Calculate the price of the 7-year bond:

Price on 7-year Bond:

Present value = ?
Future value = -100
Yield = 5.1271
Number of years = 7
Payment = -5

Compute PV (price) = 99.2679

LOS 52.f: Calculate and interpret yield measures for fixed-rate bonds, floating-rate notes, and
money market instruments.

Yield measures for fixed rate bonds

Up until now, we have been dealing with bonds that pay interest semiannually. You may, however,
encounter bonds that pay interest annually, and it is, therefore, necessary to know how to adjust the
yield to compare it to a bond that pays interest semiannually. You will find that in practice U.S. bonds
pay interest semiannually, but non-U.S. bonds will often pay interest annually.

The effective yield on the bond will depend on the number of coupon payments made on the bond per
annum. The frequency of coupon payments is called the periodicity of the annual rate.

Converting from a yield on an annual basis to a bond-equivalent yield

If you are given the yield to maturity on an annual pay bond, the formula to convert this to a bond
equivalent yield is as follows:

Bond-equivalent yield = 2[(1 + yield on annual pay bond) 0.5 - 1]

The formula in the brackets calculates the semiannual yield, which is then doubled to get the bond-
equivalent yield.

Example: Converting from a bond-equivalent yield to a yield on an annual basis

The yield to maturity on an annual pay bond is 5%. The bond-equivalent yield is:

2[(1.05) 0.5 - 1] = 4.94%

18

If you are given a bond-equivalent yield, the formula to convert this to an annual pay basis is as follows:

Yield on a bond equivalent basis h
Yield on an annual basis = ab1 + g − 1j
2

Example: Yield on an annual basis

Using the example above convert the bond-equivalent yield of 4.94% to a yield on an annual basis.

0.0494 h
2

= 5%

Remember: The yield on an annual pay bond is always greater than the yield on a bond equivalent
basis because of compounding (this is a very important concept to understand at this point).

Day count conventions

Bond yields are normally quoted using the street convention. In this method, the yield represents the
internal rate of return of the bonds cash flows and assumes that payments are made on the scheduled
date irrespective of when that date falls out on, i.e. even if it falls out on a public holiday, etc.

The true yield assumes that payments are not made on days like weekends or public holidays but
rather on the next working day.

The true yield will never be higher than the street convention yield.

We will now take a look at the various day count conventions:

There are different day count conventions that you will come across.

Actual/Actual uses the actual number of days.

Assume that the settlement date is January 5 and the next coupon date is March 15.

The actual number of days is calculated as follows:

January 5 to January 31 26 days
February 28 days
March 1 to March 15 15 days
69 days

Note the settlement date (5 January) is not counted

U.S. government bonds use this convention

30/360 day count convention assumes each month has 30 days, and that there are 360 days in a year.
Using our example above the number of days are:

January 5 to January 31 25 days
February 30 days
March 1 to March 15 15 days
70 days
19

Note the settlement date (5 January) is not counted

Agency, municipal, and corporate bonds use this convention.

Current yield

The current yield relates the annual dollar interest to the market price.

The formula for the current yield is:

Annual dollar coupon interest
Current yield =
Price of the bond

Note:

Sometimes the coupon rate is referred to as the nominal yield.

Example: Calculating current yield

Calculate the current yield for a 5% 6-year bond whose price is 96.32 with a par value of 100:

Step 1:


Current yield =
Price of the bond

Step 2:


Annual dollar coupon interest = 0.05 x $100 = $5
Price = $96.32
Current yield = ?

Step 3:

Solve for the unknown

$5
Current yield = = 0.0519
$96 .32

= 5.19%

The following can be said about the current yield:

• If the bond is selling at a discount, the current yield will be > than the coupon rate
• If the bond is selling at a premium, the current yield will be < than the coupon rate
• If the bond is selling at par, the current yield will = the coupon rate.


20
Limitations:

The current yield only considers the coupon interest, and no consideration is given to capital gains or
losses or to reinvestment income.

Note:

In the example above the bond was selling at 96.32. In this case, we used a value of 100 for the FV.

Had the question said the bond was selling at 963.20, we would have used a FV of 1,000.

Simple yield

The simple yield is the calculated as follows:

• Sum of the coupon payments for the year
• Add/subtract the straight line amortization of the gain (loss) from purchasing the bond at a discount
(premium) to par value.

Divided by

• The price of the bond

Yield to call

When a bond is callable, it is possible to calculate a yield to the call date (assuming that the call will be
exercised). If one assumes that the call will not be callable, then the yield to maturity can be calculated.

As a callable bond may have more than one call date, investors usually calculate a yield to first call and
a yield to first par call.

A yield to call is the yield that will make the present value of the expected cash flows (assuming that the
bond will be called) equal to the market price of the bond plus accrued interest.

The expected cash flows are the coupon payments to the call date and the call price (treated as if this
was the maturity value).

Note:

For a callable bond, yield-to-call is a more conservative measure of yield whenever the bond is priced at
or above its call price. It assumes that the bond will be called, so the investor knows what his minimum
return will be. This has to be considered in conjunction with the yield to maturity when making
investment decisions.

Example: Calculating yield to first call

A 5% semiannual 10-year bond with a maturity of $100 is selling for 105.24. The first call date is 3 years
from now, and the call price is $102. Calculate the yield to first call.


21
Step 1:

Determine the cash flows

The cash flows for the bond if it is called in three years’ time are:
1. 6-coupon payments of $2.5 each every six months (coupon payments up to call date)
2. $102 in six 6-month periods from now (the call price)

Step 2:

Calculate the yield to first call

105.24 [PV], 2.5 [PMT], 6 [n], 102 [FV], [i] = 1.886%

But this is the semiannual yield as the payments are made semiannually. Thus the bond-equivalent yield
to first call is 3.772% (1.886 x 2)
But this is the semiannual yield as the payments are made semiannually. Thus the bond-equivalent yield
to first call is 3.772% (1.886 x 2)

The yield to first call requires the following assumptions:

• All cash flows will be reinvested at the yield to call until the call date.
• The investor will hold the bond to the call date
• The issuer will call the bond on the call date

Yield to worst

As bonds often contain numerous put dates, call dates and also a maturity date, yields are calculated for
every possible event date. The lowest of all these possible yields is called the yield to worst.

Option-adjusted yield

When bonds contain embedded options, for example, call options, we value the options as follows:

The value of a callable bond is = Value of an option-free bond - Value of the call option.

The option-adjusted yield is arrived at by adding the value of the of the call option to the current (flat)
price of the bond.

The option-adjusted yield will be lower than the yield to maturity on a callable bond. This is because a
callable bond offers higher yields to compensate the investor for the call option – which is a benefit to
the issuer.

Floating rate notes (FRN) yields

Discount margin measures for floating-rate securities

The coupon rate for a floating-rate security is dependent on a reference rate (such as LIBOR). What will
normally happen is that it will be a one month, or three-month rate that is reset every month or three-
monthly.

The yield to maturity can never be estimated as we cannot estimate the future interest rates, and as a
result, can never estimate the future cash flows.


22
With floating rate securities we focus on the spread implied in the price of the security rather than on
any yields.

The method of calculating the spread that we will focus on is the discount margin. The discount margin
estimates the average margin over the reference rate that the investor can expect to earn over the life of
the security.

The steps to calculate the discount margin are as follows:

1. Determine the cash flows assuming that the reference rate does not change over the life of the
security
2. Calculate the YTM using your calculator
3. Subtract the current reference rate from the YTM

If the security is selling at par, the discount margin is simply the quoted margin in the coupon reset
formula. This is because the security is trading at the reference rate plus the quoted margin.

Example: Calculating the discount margin

A semiannual coupon bond with a 6-year maturity pays 90 basis points over LIBOR. LIBOR is currently
at 4%, and the bond is trading at 98.54. Calculate the discount margin.

Step 1:

Determine the cash flows

1. The coupon will be $100 x (0.04 + 0.009)/2 = $2.45. Thus the bond will make twelve 6-monthly
coupons of $2.45.
2. The maturity cash flow will be $100 in twelve 6-monthly period’s time.

Step 2:

Calculate the YTM

12[n], 2.45 [PMT], 100 [FV], 98.54 [PV], [i] = 2.5931

YTM = 2.5931%

In order to annualize the YTM we double it:

2.5931% x 2 = 5.1863%

Step 3:

Subtract the reference rate from the YTM

Discount margin = 5.1863 – 4.0 = 1.1863 or 119 basis points

Limitations
• It assumes that the reference rate will not change over the life of the instrument
• If the floating-rate security has a cap or floor, this is not considered.


23
Yields measures for money market instruments

The following types of yield can be calculated for money market instruments:

Bank discount yield

Pure discount instruments (an instrument that pays interest as the difference between the amount
borrowed and the amount paid back – such as a zero-coupon bond or T-bill) are quoted on a bank
discount basis, rather than on a price basis.
The yield on a bank discount basis is calculated as follows:

D 360
r = x
F t
Where:

r = the annualized yield on a bank discount basis
D = the dollar discount, which is = Face value of bill (F) – its purchase price
F = the face value of the bill
t = the number of days remaining to maturity (actual).
360 = bank convention number of days in a year.

Note:

Face value is the same as par value

Example: Calculating the bank discount yield

A T-bill with a par value of $100,000 and 220 days to maturity is trading at $95,600. What is the bank
discount yield?

Step 1:

z |GF
The formula to calculate the bank discount yield is: r = { x ,

Step 2:


D = F – purchase price
= $100,000 - $95,600
= $4,400

t = 220
F = $100,000
R = ?


24
Step 3:


4,400 360
r = x
100,000 220

= 0.044 x 1.6364

= 0.072

= 7.2%

The bank discount yield is 7.2%.

This yield is not meaningful because:

• The yield is based on the face value of the bond, and not on its purchase price. Returns should rather
be evaluated relative to the amount that is invested.
• The yield is annualized on a 360-day year rather than a 365-day year.
• The bank discount yield annualizes with simple interest, which ignores the opportunity to earn
interest on interest (that is, compound interest)

Holding period yield

The holding period yield is the return that an investor will earn if the T-bill is held until maturity. The
formula is as follows:

P@ − PF + DF
HPY =
PF

Where:

P0 = the initial purchase price of the instrument
P1 = the price received for the instrument at its maturity
D1 = the cash distribution paid by the instrument at its maturity (that is, interest)

Note:
For an interest-bearing bond (a bond that pays interest based on the principal) - The purchase and sale
prices must include any accrued interest if the bond is traded between interest payment dates.

Note:
For a pure discount instrument - For a T-bill, D1 = 0 as it does not make interest payments.

Example: Calculating the holding period yield

A T-bill with a par value of $100,000 and 220 days to maturity is trading at $95,600. What is the holding
period yield?

Step 1:

~ [~ Az
The formula for the holding period yield is HPY = I ~W W
W


25
Step 2:


D = 0 as a T-bill is a pure discount instrument and does not pay interest
P1 = $100,000
P0 = $95,600
HPY = ???

Step 3:


@FF,FFF[SD,GFFAF
HPY = SD,GFF

= 0.046

= 4.6%

Remember that we don’t annualize the HPY. As a result, the 4.6% is the return over the 220-day period.
This is very important to remember for your exam.

The disadvantage of the HPY is that it does not give an indication of the annualized return that will be
made on the investment.

Effective annual yield

The effective annual yield is an annualized yield based on a 365-day year. The yield also accounts for
compound interest. The formula for the effective annual yield is as follows:

|GD
EAY = (1 + HPY) , − 1

Example: Calculating the effective annual yield

Using our HPY example above calculate the EAY.

As we have already calculated the HPY all we need to do is substitute this into the equation as follows:

|GD
EAY = (1 + HPY) , − 1
365
= (1 + 0.046) - 1
220
= 0.0775
= 7.75%

Always remember, that for the same example, the bank discount yield will always be lower than the
effective annual yield as long as the investment is for less than 365 days. You can see this from our
example.

Money market yield (also known as the CD equivalent yield)

As money market instruments are quoted as a money market yield, it is important to know how to
calculate the money market yield for a T-bill. As a T-bill is quoted as a bank discount yield, the formula
below shows how to convert from the bank discount yield to the money market yield.

26
360 x r‚z
r•• =
360 − (t x r‚z )

Where rBD is used to refer to the bank discount yield and the rMM to the money market yield.

Example: Calculating the money market yield

Using our example above, calculate the money market yield.

As we have already calculated the bank discount yield, it is easy to substitute this into the equation and
calculate the money market yield.

360 x r‚z
r•• =
360 − (t x r‚z )

360 x 0.072
=
360 − (220 x 0.072)

= 0.0753 or 7.53%

Thus, the money market yield is 7.53%

LOS 52.g: Define and compare the spot curve, yield curve on coupon bonds, par curve, and
forward curve.

The yield curve

The yield curve illustrates the relationship between the yield-to-maturity on the bond and its term-to-
maturity.

The yields that are used to graph the yield curve should be of the same quality and risk.

The spot rate curve

The spot rate curve represents those rates that we use to discount single payments in the future. Based
on this the curve will also be called the zero-coupon curve.

The yields on zero-coupon bonds are the spot rates.

Yield curve for coupon bonds

This curve will show the yield-to-maturity for the bonds at all the different maturities.

For those maturities where there are no active bonds, the yields will be estimated via interpolation.

Par bond yield curve

The par bond curve works on a series of yield-to-maturities (YTM) where each YTM is arrived at by
making sure that the bond trades at par.
The par bond curve is derived from the spot rate curve.


27
Forward rates

Forward rates can be viewed as the market’s consensus of future yields / rates.

Examples of forward rates that can be calculated from the default-free theoretical spot rate:

• 6-month forward rate six months from now
• 6-month forward rate 3 years from now
• 1-year forward rate one year from now
• 3-year forward rate two years from now
• 5-year forward rate three years from now

Forward rates are implicitly extrapolated from the default-free theoretical spot rate curve and are
sometimes referred to as implied forward rates.

The forward yield curve will show the forward rates for the various maturities.

LOS 52.h: Define forward rates and calculate spot rates from forward rates, forward rates from
spot rates, and the price of a bond using forward rates.

Forward rates and how to calculate them

We can use spot rates into the future in order to calculate forward rates. A forward rate is an interest
rate that is set for a period of time for a starting date in the future. These forward rates are rates such
as:

• 6-month forward rate six months from now
• 6-month forward rate one year from now
• 3-year forward rate two years from now

How to calculate a 6-month forward rate

Let’s work through this in the form of an example: Let’s consider an investor who has a 1-year
investment horizon and is faced with the following two alternatives:

a. Buy a 1-year Treasury bill
b. Buy a 6-month Treasury bill, and when it matures in six months buy another 6-month Treasury bill

The choice wouldn’t matter if the investor knew he would get the same return. The investor, however,
does not know what the 6-month rate will be 6-months from the time of entering into the trade.
Below we will show you how to calculate this rate given the 1-year rate and 6-month rate.

Always remember that if you are given a bond-equivalent yield, you need to divide it by two to get a
comparable semiannual yield.

Let Z 2 = one-half of the bond-equivalent yield of the theoretical 1-year spot rate.
Let Z 1 = one-half of the bond-equivalent yield of the theoretical 6-month spot rate.
Let f = one-half the forward rate (expressed as a bond-equivalent yield) on a 6-month treasury bill
available six months from now.

The reason we take one-half of the yield each time is because we need to compare 6-monthly yields


28
Thus, if an investor purchased a 6-month bill for $X, the value at the end of six months would be:

X(1 + Z1)

This is based on the formula FV = PV(1 + i)n

If the investor were to roll this amount over into another 6-month treasury bill in six months time the
value in one year from the $X investment would be:

X(1 + Z1)(1 + f)

However, if the investor had purchased a 1-year Treasury bill, the value in one year’s time would be:

X (1 + Z2)(1 + Z2) Or X(1 + Z2)2

We assume that the rates are a function of each other and thus we can calculate the 6-month rate six
months from now by making the two equations equal as follows:

X (1 + Z2)(1 + f) = X(1 + Z2)2

Solving for f, we get:

(1 + Zh )h
𝑓 = − 1
(1 + Z@ )

If we then double f, we get the bond-equivalent yield for the 6-month forward rate six months from
now.

Example: Calculating forward rates

The 6-month bill spot rate = 2%
The 1-year bill spot rate = 2.2%

We need to convert these rates into 6 monthly rates, therefore:

Z 1 = 1%
Z 2 = 1.1%

Substituting into the formula we get:

(@A†J )J
f =
( @A†I )

(@AF.F@@)J
f =
(@AF.F@)

f = 1.2%

Therefore, the 6-month forward rate six months from now is 2.4% (1.2%x2)


29
Note:

The forward rate of 2.4% is greater than either of the rates used to calculate it (i.e. 2 and 2.2%). This is
because an upward sloping yield curve forecasts rising short-term rates and vice versa.

Remember you can always test that you obtained the right answer by calculating the value of your
investment at the end and using the two different methods.

This formula can be used for any time period. For example, the formula to calculate the 6-month
forward rate four years from now would be:

(@A†‡ )‡
f =
( @A†Y )Y
- 1

The 8 represents 4-years of six monthly periods from now (4 x 2). As we are looking for the 6-month
rate 4 years from now, the end of the period is 9 6-monthly periods from now.

Let’s try a few more examples to see the pattern.

What would be a one-year forward rate 2 years from now?
(@A†‡ )K
f =
( @A†J )J
− 1

How would you calculate the implied forward rate for 5 years beginning 2 years from now?

(@A†X )X
f =
( @A†J )J
- 1

Relationship between spot rates and short-term forward rates

The relationship between spot rates and short-term forward rates is that short-term forward rates must
always be a function of the spot rates. An investor must be able to get the same return by investing in a
3-year investment as he would by investing in 6, half year investments.

Thus the 3-year rate will depend on the 6-month spot rate and the five forward 6-month rates.

Compute spot rates given forward rates and vice versa

As we described above, spot rates are made up of a series of forward rates. Consider the scenario above
with the 3-year investment. The value of an investment of $X in a 3-year zero-coupon Treasury security
is:

FV = PV(1 + i)n

As we are working with semiannual interest rates, the n is expressed in 6-monthly periods. Thus 3 years
is 6 n (3 x 2).

X(1 + Z 6 )6

Note:

The Z in this equation is a semiannual rate as we described above.


30
If the investor had purchased the 6-month Treasury bill and reinvested the proceeds for the 3-year
period the value of the investment would be:

X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

As these two values will generate the same proceeds we can make the two formulae equal each other as
follows:

X(1 + ZG )G = X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

Example: Calculating spot rates

You are presented with the following bond-equivalent rates:

Notation Bond-equivalent rate
Z1 3.00
f1 3.10
f2 3.20
f3 3.20
f4 3.50
f5 3.60

Calculate the 3-year spot rate.
Step 1:

Convert the bond-equivalent rates into semiannual rates.

Notation Bond-equivalent rate Semiannual rate
Z1 3.00 1.50
f1 3.10 1.55
f2 3.20 1.60
f3 3.20 1.60
f4 3.50 1.75
f5 3.60 1.80

Step 2:

Calculate Z 6 using the formula

X(1 + Z 6 ) 6 = X(1 + Z 1 )(1 + f1 )(1 + f 2 )(1 + f 3 )(1 + f 4 )(1 + f 5 )
1
Z 6 = [(1 + Z 1 )(1 + f1 )(1 + f 2 )(1 + f 3 )(1 + f 4 )(1 + f 5 )] 6 - 1
1
Z 6 = [(1.015)(1.0155)(1.016)(1.016)(1.0175)(1.018)] 6 - 1
1
Z 6 = [1.1021] 6 - 1
Z 6 = 1.63%

Step 3:

Convert the rate to a bond-equivalent rate (i.e. the annual rate)
In order to convert the rate to a bond-equivalent rate we need to multiply it by 2 as follows:
1.63% x 2 = 3.27%

31

The 3-year spot rate is 3.27%
Example: Calculating implied forward rates

An investor can purchase a Treasury bond that matures in 2 years and pays 4.5%, or he can invest in a
one-year Treasury bond paying 4% and invest the proceeds after one year in a further one-year
Treasury bond. What would the implied forward rate on the one-year treasury one year from now have
to be for the investor to earn the same using either method?

Step 1:


If the investor purchases the 2-year bond his future value will be:
X(1 + i)n

If the investor purchases the 1-year bond and invests the proceeds in a further 1-year bond his future
value will be:
X(1 + Z1) x (1 + f1)

As we are required to calculate what the implied forward rate will be to get to the same value, we can
make the equations equal each other, as they are required to produce the same value.

Therefore:

X(1 + i)n = X(1 + Z1) x (1 + f1)

Step 2:


i = 4.5%
n = 2
Z1 = 4%
f1 = ?

Step 3:

X(1 + i)n = X(1 + Z1) x (1 + f1)
(1 + 0.045)2 = (1 + 0.04) x (1 + f1)
1.092 = 1.04 x (1 + f1)
1.05 = 1 + f1
f1 = 0.05
f1 = 5%

The implied forward rate that would yield the same return after two years is 5%.

Valuation using forward rates

We know that a spot rate is just a package of short-term forward rates – therefore we can discount our
cash flows by either the spot rate or the forward rates.


32
The formula for valuation using forward rates will be:

PV of $1 in T periods =

1

(1 + z@ )(1 + 1f1)(1 + 1f2)(1 + 1f3) … (1 + 1f‹[@ )

This can also be called the forward discount factor for period T.

Example: Calculating PV using forward rates

The following rates were available:

z1 = 3.00% / 2 = 1.5%
1f1 = 3.60% / 2 = 1.8%
1f2 = 3.92% / 2 = 1.958%
1f3 = 5.15% / 2 = 2.577%

To calculate the PV factor we use the formula:

@
(@ A ŒI )(@ A @7@)(@ A@7h)(@ A @7|)…(@ A @7•PI )

@
(@.F@D)(@.F@T)(@.F@SDT)(@.FhDHH)

PV of $1 in T periods = 0.925369

We could also calculate the PV factor using the 4-period spot rate – which was calculated at 3.9164%.

Z4 = 3.9164% / 2 = 1.9582%

@
(@.F@SDTh)Z

PV of $1 in T periods = 0.925361

The same answer as when discounting using forward rates (slight difference due to rounding)

Based on this is does not matter whether rates are discounted using spot rates or forward rates – the
value will be the same.

LOS 52.i: Compare, calculate, and interpret yield spread measures.

The yield spread between two bonds is calculated as:

Yield spread = yield on bond X – yield on bond Y

Where bond Y is considered the reference bond or benchmark against which bond X will be measured.

When a yield spread is measured in this way, it is called an absolute yield spread.

Yield spreads can also be measured on a relative basis. This is called the relative yield spread.

33

Ž;183 9< ‚9<3 •[Ž;183 9< M9<3 Ž
Relative yield spread = Ž;183 9< M9<3 Ž

A yield spread relative to a benchmark, e.g. to a Government bond, is called benchmark spread.

If the benchmark being used is the U.S. Treasury, then the bonds’ spread over the U.S. Treasury is called
the G- spread.

Spreads relative to swaps rates are called I-spreads (interpolated spreads).

Nominal spreads, Zero volatility spreads, and option-adjusted spreads

When dealing with a non-Treasury bond, we calculate the spread between the Treasury and a non-
Treasury – this traditional yield spread is known as the nominal spread.

This nominal spread measures the compensation for the additional credit risk and liquidity risk that the
investor is exposed to when investing in a non-treasury security as opposed to a treasury security with
the same maturity.

Zero-volatility spread

The zero-volatility spread or Z-spread is the measure of the spread that an investor would realize
over the entire Treasury spot rate curve if the bond was held to maturity.
As opposed to the traditional measure of the nominal spread it is not the spread at a once off point on
the curve, but rather it is a spread over the entire theoretical treasury spot rate curve.
The z-spread is also called the static spread; it is the spread that will make the PV of all the cash flows
from a non-treasury bond equal the price of a non-treasury bond when discounted at the treasury spot
rate plus the spread.

A trial and error procedure is needed to determine the Z-spread.

When calculating the Z-spread, we must have:

• A treasury spot rate for all the maturities on the curve (the method to calculate this has already
been shown in the previous section – the method used was bootstrapping)
• The price of the non-treasury bond
• The coupon on the non-treasury bond

Steps to calculate the z-spread:

• Present value all of the cash flows at the spot rate + an estimated spread.
• Do this procedure until such time as the sum of all the cash flows, once discounted,

Option-adjusted spread

The option-adjusted spread will take care of the issue that if the bonds are callable or putable, then the
expected interest rate volatility may change the cash flows on the non-treasury bond.

Valuation models

A valuation model is used to determine the fair value of a security.
A valuation model can also take the difference between the fair price (determined by a valuation model)
and the market price and convert it to a yield spread measure.
i.e. the model can show how much return will be earned in exchange for taking on the risk of investing.

34
The option-adjusted spread (OAS) takes the dollar difference between the fair price and the market
price and converts it into a yield spread measure.
The OAS seeks to find a return (spread) that will equate the market price and the fair price (value). It
will do this via trial and error.

OAS is model dependent – i.e. it will depend on the valuation model used. These models differ as to how
they forecast interest rate changes. This is turn will lead to a variation in the level of OAS.
These assumptions are:

• Interest rate volatility. The higher the interest rate volatility that is being assumed, the lower the
OAS.
• The OAS is a spread over the treasury spot rate. The spot rate calculation is in itself a series of
assumptions. These assumptions will also yield different results.

The OAS is called option adjusted because the security’s embedded options can change the cash flows of
the security. The value, therefore, will need to take into account this change of cash flow.
Keep in mind that Z-spread did not take into account the change in cash flows – i.e. it assumed that the
interest rate volatility is zero.
Z-spread is therefore also referred to a zero-volatility OAS.

Option cost

The cost of the option embedded in the security can be obtained by calculating the difference between
the OAS at the assumed yield volatility and the Z-spread. Since the z-spread is just the sum of the OAS
and the option cost.

Z-spread = OAS + option cost

Therefore:

Option cost = Z-spread- OAS

The reason for this is that in an environment when interest rate are not expected to change then the
investor will earn the z-spread.

When rates are expected to change or are uncertain, then the spread will change due to the embedded
option. The OAS reflected this spread after adjusting for the option.

For callable bonds the option cost is positive.
For putable bonds the option cost is negative.


35
SUMMARY
Reading 52 – Introduction to Fixed-Income Valuation

The fundamental principles of bond valuation

The value of a fixed income security is equal to the present value of the security’s expected cash flows. The process is:

1. Estimate the expected cash flows.

2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows using the interest rate determined.
4. Sum the present values together to determine the valuation.

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐢𝐧 𝐩𝐞𝐫𝐢𝐨𝐝𝐭
The formula for present value, =
(𝟏A𝐢)𝐭

The discount rate and the effect on the bond’s value

1. The greater the length of time from the valuation date to the date of the cash flow, the lower the present value.
2. The higher the discount rate, the lower the bond’s value.
3. The lower the discount rate, the higher the bond’s value.

discount rate = ¯bond value

¯discount rate = bond value

Yield-to-maturity
The yield to maturity (YTM) is the interest rate that will make the present value of the bond’s cash flows equal its market
price + accrued interest. This is also known as the average interest rate or yield on the bond. The YTM is also known as the
Internal rate of return (IRR).

Coupon vs Yield

Type of bond Price of bond Yield vs Coupon YTM vs coupon rate

Premium bond Greater than par Coupon > yield Coupon > YTM
Discount bond Less than par Coupon < yield Coupon < YTM
Par value bond At par Coupon = yield Coupon = YTM

Coupon rate
All else being equal, the lower the coupon rate, the more sensitive the price of the bond to changes in the yield.

Maturity
All else being equal, the longer the maturity of the bond the more sensitive the price of the bond to changes in the yield.

Pull to par value - At the maturity date, the bond’s value is always equal to its par value.

Spot rates

Yield-to-maturity - The average yield across the life of the bond.

Spot rate - It is correct to use a different discount (interest) rate for each different cash flow date (not an average rate). The
rate that we use is the spot rate. The spot rate is the rate that we would use to discount zero-coupon bonds and are often
referred to as the zero coupon rate.

Bond valuation between coupon payments, calculating dirty price, accrued interest, and clean price

If you are asked to value a bond between coupon payments we need to take into account the interest earned by the seller from
the last coupon payment date to the settlement date that is called the accrued interest. The buyer needs to compensate the
seller for this accrued interest, as the seller will receive the full coupon on the next coupon date.

Full price (dirty price) -The full price is the price taking into account accrued interest (also referred to as the dirty price). It is
this price that the buyer pays the seller.
Full price = clean price + accrued interest.

Clean price (flat price) - This is the price excluding the accrued interest.
Clean price = Dirty price – accrued interest.

Example:

On 1 November 20x2 you decide to sell a bond that will mature on 31 December 20x4. The bond is a semiannual bond with a
coupon of 10%, and the annual discount rate is 8%. The bond’s coupon dates are 30 June and 31 December each year. The bond
uses a 30/360 day count convention. Calculate the full price of the bond.
Step 1: Calculate the value of the bond assuming that the sale went through at the beginning of the period, in other words at
the end of June 20x2.
FV = -100, I = 4 (8/2), PMT = -5, N = 5, PV = 104.45

36
Step 2: We now need to adjust the price upwards to reflect the fact that the bond was in fact sold at a later date (and not at the
end of June 20x2, the valuation date). The bond was sold on the 1st of November 20x2, which was 121 days later.

The full price is calculated as follows:

= 104.45 x (1 + 0.04)121/180
= 107.24

Accrued interest = 5 (payment) x 121/180 = 3.36.

Matrix pricing
Matrix pricing is a method that is used to estimate the discount rate used to price bonds that are not actively traded.

Yield measures for fixed rate bonds

1. Converting from a yield on an annual basis to a bond-equivalent yield

0.5
Bond-equivalent yield = 2[(1 + yield on annual pay bond) - 1]

2. Converting from a bond-equivalent yield to a yield on an annual basis

Yield on a bond equivalent basis h
2

3. Current yield
Current yield =

Price of the bond
4. Yield to call
When a bond is callable, it is possible to calculate a yield to the call date (assuming that the call will be exercised).

5. Yield to worst
Yields are calculated for every possible event date. The lowest of all these possible yields is called the yield to worst.

6. Option-adjusted yield
When bonds contain embedded options, for example, call options, we value the options as follows:
The value of a callable bond is = Value of an option-free bond - Value of the call option.

Yield measures for floating rate notes (FRN)

Discount margin measures for floating-rate securities

With floating rate securities we focus on the spread implied in the price of the security. We use the discount margin that
equals the average margin over the reference rate that the investor can expect to earn over the life of the security.

Yields measures for money market instruments

1. Bank discount yield

D 360
r = 𝑥

F t
Where:
r = the annualized yield on a bank discount basis
D = the dollar discount, which is = Face value of bill (F) – its purchase price
F = the face value of the bill
t = the number of days remaining to maturity (actual).

2. Holding period yield

P@ − PF + DF
HPY =
PF
Where:
P0 = the initial purchase price of the instrument
P1 = the price received for the instrument at its maturity
D1 = the cash distribution paid by the instrument at its maturity (that is, interest)

3. Effective annual yield

|GD
EAY = (1 + HPY) , − 1

4. Money market yield (also known as the CD equivalent yield)
360 x r‚z
r•• =
360 − (t x r‚z )

Where rBD is used to refer to the bank discount yield and the rMM to the money market yield.


37
Forward rates

Forward rates can be viewed as the market’s consensus of future yields / rates.
(@A £J )J
Forward rate = 𝑓 = (@A £I )
− 1
Relationship between spot rates and short-term forward rates

The relationship between spot rates and short-term forward rates is that short-term forward rates must always be a function
of the spot rates. An investor must be able to get the same return by investing in a 3-year investment as he would by investing
in 6, half year investments.

Computing spot rates given forward rates and vice versa

Consider a 3-year investment paying semi-annually. If the investor had purchased the 6-month Treasury bill and reinvested the
proceeds for the 3-year period the value of the investment would be:

X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

As these two values will generate the same proceeds we can make the two formulae equal each other as follows:

X(1 + ZG )G = X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

Valuation using forward rates

The formula for valuation using forward rates will be:

@
(@ A Œ )(@ A @7@)(@ A@7h)(@ A @7|)…(@ A @7

I )
•PI

Various yield spreads

Absolute yield spread = yield on bond X – yield on bond Y

Ž;183 9< ‚9<3 •[Ž;183 9< M9<3 Ž
Relative yield spread = Ž;183 9< M9<3 Ž

A benchmark spread = a yield spread relative to a benchmark, e.g. to a Government bond.

G- spread = If the benchmark that is being used is the U.S. Treasury.

I-spreads (interpolated spreads) = spreads relative to swaps rates.

Nominal spreads, Zero volatility spreads, and option-adjusted spreads

Nominal spread - The traditional yield spread between the Treasury and a non-Treasury.
The zero-volatility spread or Z-spread (static spread) - The measure of the spread that an investor would realize over the
entire Treasury spot rate curve if the bond was held to maturity.
Option-adjusted spread - The option-adjusted spread will take care of the issue that if the bonds are callable or putable, then
the expected interest rate volatility may change the cash flows on the non-treasury bond.
• For callable bonds the option cost is positive.
• For putable bonds the option cost is negative.


38
EDGE CHECKERS

1. The 3-year spot interest rate is 7 percent, and the 4-year spot interest rate is 8 percent. Assuming annual
compounding, which of the below is nearest to the 1-year interest rate 3 years from now?

A. 11.0%
B. 7.5%
C. 6.0%

2. If an 8-year, $1,000 U.S. zero-coupon bond is priced to yield 11.25 percent, which of the below is nearest to its
market price (assuming semi-annual compounding)?

A. $416.61
B. $426.19
C. $645.46

3. What value would an investor place on a 10-year, 9 percent annual coupon bond, if the investor required a
7.75 percent rate of return?

A. $1,085
B. $775
C. $980

4. The current three-year spot rate is 10 percent, the current one-year spot rate is 7 percent, and the one-year
forward rate for one year is 9 percent. Which of the below is nearest to the one-year forward rate starting two
years from now?

A. 14.12%
B. 8.67%
C. 13.31%

5. A 2-year option-free bond (par value of $1,000) has an annual coupon of 8 percent. An investor determines
that the spot rate of year 1 is 5 percent and the 2-year spot rate is 7 percent. Using the arbitrage-free valuation
approach, the bond price is closest to:

A. $1,087.00
B. $943.00
C. $1,019.50

6. Which of the below is not 1 of the main yield spreads?

A. The current yield on a bond compared with its yield in the past
B. Bonds with different maturities
C. Corporate bonds vs. T-bonds

7. What is the discount rate of a treasury bill that has 120 days remaining to maturity and whose price is $98.15
per $100 maturity value? (Assume 360-day convention count)

A. 1.89%
B. 1.85%
C. 5.55%

39
8. An investor purchases a 15-year, 8.75 percent semi-annual bond for $925, nominal value $1,000. He expects
to sell the bond in 2 years when he estimates yields will be 8.75 percent. What is his estimate of the future
price?

A. $1,100
B. $925
C. $1,000

9. An upward sloping yield curve is also termed as:

A. Twisted
B. Flat
C. Normal

10. Deliberate the bond below. Which answer is nearest to its price relative to par and what is the most probable
ranking of its coupon rate and yield?

Price: 115
Coupon: 15

A. Premium, yield greater than coupon
B. Premium, coupon greater than yield
C. Discount, yield greater than coupon

11. A bond analyst makes the subsequent announcements on the shape of the yield curve? Which of these
announcements is/are least precise?

Announcement X: “the normal yield curve is flat.”
Announcement Y: “the inverted yield curve is upward sloping.”

A. Both announcements X & Y
B. Announcement X
C. Announcement Y

12. A 20-year, 8.5 percent semi-annual coupon bond is selling for $895. The par value is $1,000. The bond's
current yield is nearest to:

A. 9.71%
B. 8.50%
C. 9.50%

13. If an investor sells a bond at par before its maturity, they will make a capital gain if:

A. Interest rates at the date of sale are lower than interest rates at the time the bond was issued
B. She purchased the bond at a premium
C. Interest rates at the date of sale are greater than interest rates at the time the bond was issued

14. A bond analyst makes the following declarations on spot rates. Which of these declarations is/are most
precise?

Declaration A: “The Treasury spot rate yield curve provides the discount rates to be used in valuing cash flows
from Treasury securities.”
Declaration B: “Each maturity will have its own spot rate.”

A. Both declarations A & B
B. Declaration A
C. Declaration B


40

15. A bond analyst makes the below proclamations on how embedded options affect yield spreads? Which of
these proclamations is most accurate?

Proclamation 1: The spread will be wider for a callable bond than for an option-free bond.
Proclamation 2: The spread will be narrower for an option-free bond than for a putable bond.

A. Both proclamations 1 & 2
B. Proclamation 1
C. Proclamation 2

16. Given the subsequent data, calculate the yield to maturity:

Par value: $1,000
Annual coupon: 5.25%
Maturity: 4 years
Price: $821

A. 11%
B. 9%
C. 10.5%

17. A 25-year, 10.5 percent bond that pays interest annually is discounted priced to yield 12.5%, i.e. the discount
rate is 12.5%. However, interest payments will be invested at 10.5%. The realized compound yield on this
bond is nearest to:

A. Between 10.5% and 12.5%
B. <10.5%
C. >12.5%

18. A coupon paying bond pays annual interest, has a par value of $1,000, matures in 2 years, has a coupon rate of
10.85%, and a yield to maturity of 11.25% percent. The current yield on this bond is nearest to:

A. 11.25%
B. 10.85%
C. 10.92%

19. A 5-year, semi-annual 10.25 percent coupon bond has a maturity value of 1,000 selling for $1069.15. The first
call date is 3 years from now, and the call price is $1,045. What is the yield-to-call?

A. 4.46%
B. 8.92%
C. 7.62%

20. Which of the below yield measures is most suitably used as the yield to the first date in which the issuer can
call back a bond?

A. Yield to refunding
B. Yield to first call
C. Yield to first par call date


41

21. You are provided with the subsequent data on a bond.

Face value: $1,000
Maturity: 10 years
Annual pay coupon: 8.75%
Yield to maturity: 7.75%

What would be the bond’s price if yields drop by 150 basis points?

A. $1,181.84
B. $1,067.86
C. $1,000.00

22. Which of the below is nearest to the price an investor would pay for a 15-year principal strip if the required
return is 9%? Assume par value is $1,000 and semi-annual compounding.

A. $274.54
B. $267.00
C. $1000.00

23. Reflect a situation where the spread between the 30-year Treasury yield and the 2-year Treasury yield is -20
basis points. This proposes that the term structure is:

A. Downward sloping
B. Flat
C. Upwards sloping

24. Given the subsequent spot rate curve:

Spot Rates
1-yr zero = 8.25%
2-yr zero = 7.50%
3-yr zero = 7.00%
4-yr zero = 7.30%
5-yr zero = 7.45%

What will be the market price of a 3-year, 6 percent annual coupon rate bond?

A. $1000.00
B. $972.50
C. $973.76

25. An upward-sloping yield curve most likely shows that:

A. The price of a bond will be more volatile as it reaches maturity
B. Longer maturities have larger yields
C. Yield spreads tend to increase over time

26. Yield to call (YTC) is most probable to be a more conservative estimate of return than yield to maturity (YTM)
if the:

A. Call value is more than the current price and the nominal value
B. Bond trades at a premium
C. Bond trades at a discount


42
27. If you purchase a bond that is entitled to part or all of a coupon payment, what best defines the price you are
paying to the seller?

A. Flat price
B. Clean price
C. Full price
28. Undertake that the spread of the term structure increases from 10 basis points to 30 basis points. What does
this mean in regards to the shape of the yield curve?

A. The yield curve has become less humped
B. The yield curve has flattened
C. The yield curve has steepened

29. Calculate the value of a 4-year, zero-coupon bond with a par value of $100,000 and a yield to maturity of
4.50% (assuming semi-annual compounding).

A. $83,856.13
B. $83,693.83
C. $100,000

30. What is the yield to maturity of a 20-year bond with a semi-annual coupon rate of 9.50 percent that is
currently selling for $1,000?

A. 10.50%
B. 8.50%
C. 9.50%

31. In which of the subsequent cases will an investor most likely make a capital gain, purchasing a bond:

A. At issuance when interest rates are higher than the coupon rate
B. At a premium to par
C. Which is callable at par throughout the life of the bond

32. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 9 years, and has a yield
to maturity of 12.25%. What is the intrinsic value of the bond today if the coupon rate is 7.50%?

A. $1,000.00
B. $745.24
C. $749.29

33. In which of the next cases is the bond at a discount to par?

A. Coupon rate is lower than current yield, and current yield is lower than yield-to-maturity
B. Coupon rate is higher than current yield which is higher than yield-to-maturity
C. Coupon rate is lower than the current yield, and current yield is higher than yield-to-maturity

43
SOLUTIONS - EDGE CHECKERS

1. A The 4-year spot rate is the average of the 3-year spot and the one-year forward rate starting 3 years
from now. If we know the 3 and 4-year spot rate, we can solve for the missing forward rate. The proof is
as follows: [(1 + Z4)4 / (1 + Z3)3] – 1

= 1.084 = 1.073 X (1 + ?)1
= 1.084 / 1.073 = (1 + ?)1
= 11.06%

2. A N = 8 X 2 = 16
I/Y = 11.25 / 2 = 5.625
PV = ?
PMT = -0
FV = -1000
CPT PV = 416.61

3. A N = 10
I/Y = 7.75
PV = ?
PMT = -90
FV = -1000
CPT PV = 1,084.83

4. A The three-year spot rate is an average of forward rates. The one-year spot is a forward rate that starts
immediately.

Therefore, (1 + 0.07)(1 + 0.09)(1 + f) = (1 + 0.10)3.

= 1.103 = 1.07 X 1.09 X (1 + ?)
=1.331 = 1.1663 X (1 + ?)
= 1.331 / 1.1663 = (1 + ?)
= 14.12%

5. C The arbitrage-free valuation approach is the process of valuing a fixed income instrument as a portfolio
of zero coupon bonds. We can calculate the price of the bond by discounting each of the annual
payments by the appropriate spot rate and finding the sum of the present values. Bond Price = [80 /
(1.05)] + [1,080 / (1.07)²] = $1,019.5 Or, in keeping with the notion that each cash flow is a separate
bond, sum the following transactions on your financial calculator.

6. A Corporate bonds vs. Treasury bonds spreads define inter-market spreads. Spreads between bonds with
different maturities define intra-market spreads (spreads on the yield curve).

7. C We compute the dollar discount from nominal value: 100 - 98.15 We put this as a percentage of nominal
value: (100 - 98.15 / 100) We then annualize this rate assuming simple interest and 360 day count:
Discount rate = (100 - 98.15 / 100) * (360 / 120) = 5.55%

8. C The coupon rate of 8.75% equals the market rate, so the bond is trading at par.

9. C A 'normal' shaped yield curve is one that shows that investors require a greater rate of return for
lengthier maturity bonds, i.e. upwards sloping
10. B If the bond is above par, investors will suffer a capital loss if they hold the bond until it is redeemed at
par at maturity. Consequently, its yield must be below coupon. The coupon is set at issue, and you
assume it is issued at par of 100.

11. A Both statements are wrong. The normal yield curve is upward sloping whereas the inverted one is
downward sloping.

44
12. C Current yield = Coupon / price Current yield = $85 / $895

= 9.50%
13. A As interest rates drop bond prices increase. The investor must have bought the bond at a discount and
is now selling it at par (face value) for a capital gain. The other options reflect a purchase price higher
than the sale price.

14. A Both statements are accurate. The Treasury spot rate yield curve provides the discount rates to be used
in valuing cash flows from Treasury securities. Each maturity will have its own spot rate.
15. B A putable bond is worth more than an equivalent option-free bond, and will thus have a narrower
spread (i.e. higher price, lower yield spread). Note the question has not asked about the OAS, but a yield
spread, in general, i.e. a nominal spread.
16. A N = 4
I/Y = ?
PV = 821
PMT = -52.50
FV = -1000
CPT I/Y = 11.02%

17. A If coupons are reinvested at the YTM, the realized yield and YTM will be the same. The yield must be
above 10.5% due to the discount but will be beneath 12.5% as the YTM assumption (that coupons are
reinvested at the YTM) is not satisfied.

18. C N = 2
I/Y = 11.25
PV = ?
PMT = -108.50
FV = -1000
CPT PV = 993.17

Current yield = Coupon / price Current yield = $108.50 / $993.17
= 10.92%

19. C N = 3 X 2 = 6
I/Y = ?
PV = 1069.15
PMT = -51.25
FV = -1045
CPT I/Y = 4.46%
= 4.46% X 2 = 8.92%

20. B Yield to first par call date is the yield to the first date at which the issuer can call the bond at par. Yield
to refunding is the yield to the date when the refunding protection ends.
21. A N = 10
I/Y = 7.75 – 1.50 = 6.25
PV = ?
PMT = -87.50
FV = -1000
CPT PV = 1181.84

22. B A strip is simply a zero coupon bond.
N = 15 X 2 = 30
I/Y = 9 / 2 = 4.5
PV = ?
PMT = -0
FV = -1000
CPT PV = 267.00

45
23. A The slope of the yield curve is often described as the spread between the long and short end. A negative
spread indicates the yield curve is inverted.
24. B = 60 / (1.085)1 + 60 / (1.075)2 + 1060 / (1.07)3

= 55.30 + 51.92 + 865.28
= 972.50
25. B The yield curve plots time to maturity (x-axis) against yields (y-axis). The normal shape of the yield
curve is upwards sloping - that is, lengthier dated bonds will yield more than shorter-dated bonds. Yield
spread is the difference between the yields on two bonds. An upward-sloping yield curve implies yields
are increasing, not yield spreads as the yields on both bonds may be increasing.

26. B A more conservative estimate means that yield to call < yield to maturity. If the bond is trading at a
premium, the bond being redeemed early at the call price will most likely result in a capital loss,
reducing the yield, compared to holding to redemption. Consequently, the yield to call will be lower
than the YTM because of this capital loss. This is because the call price is probable to be under the
current price and will result in a loss if the bond is redeemed before the maturity date. If the bond is
held until redemption the coupons and reinvestment income will compensate for the capital loss,
increasing the YTM.

27. C Coupons included means dirty or full price or cum coupon; excluded means clean price or ex-coupon or
flat price. Note: Flat – this is a special case when the bond trades without a coupon because the issuer
has defaulted.

28. C The slope of the yield curve is often defined as the spread between the long and short end. A widening
spread shows the yield curve has steepened.
29. B N = 4 X 2 = 8
I/Y = 4.50 / 2 = 2.25
PV = ?
PMT = -0
FV = -100,000
CPT PV = 83,693.83

30. C The bond is at par, so the YTM is the same as the coupon rate.
31. A If interest rates are greater than the coupon rate, the bond will be issued below par, which would allow
the investor to make a capital gain if the bond is held until maturity. A callable bond benefits the issuer,
not the investor of the bond.
32. B N = 9 X 2 = 18
I/Y = 12.25 / 2 = 6.125
PV = ?
PMT = -37.50
FV = -1,000
CPT PV = 745.24

33. A A bond is at a discount to par when the coupon rate is lower than the current yield, and the current
yield is lower than yield-to-maturity.


Study Session 16 Fixed Income: Basic Concepts: Reading 52

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Study Session 16 Fixed Income: Basic Concepts: Reading 52

Uploaded by

Copyright:

Available Formats

1

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

LOS 52.a: Calculate a bond's price given a market discount rate.

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

To illustrate this let’s consider an example:

The present value of the bond using our formula is:

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Example: Value of the bond using a required rate of return

Example: Calculating market yield

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Year 1: 1[n], 5[FV], 0[PMT], 6.7[i], [PV] = 4.686

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Computing the accrued interest and the clean price

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

LOS 52.e: Describe matrix pricing.

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Yields measures for money market instruments

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Example: Calculating implied forward rates

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

The formula for valuation using forward rates will be:

LOS 52.i: Compare, calculate, and interpret yield spread measures.

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

1. Estimate the expected cash flows.

­discount rate = ¯bond value

Type of bond Price of bond Yield vs Coupon YTM vs coupon rate

Yield-to-maturity - The average yield across the life of the bond.

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

The full price is calculated as follows:

Accrued interest = 5 (payment) x 121/180 = 3.36.

1. Converting from a yield on an annual basis to a bond-equivalent yield

2. Converting from a bond-equivalent yield to a yield on an annual basis

Yield measures for floating rate notes (FRN)

Discount margin measures for floating-rate securities

Yields measures for money market instruments

1. Bank discount yield

2. Holding period yield

3. Effective annual yield

Study Session 16 – Fixed Income: Basic Concepts: ©2019 Edge FIT

X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

X(1 + ZG )G = X(1 + Z@ )(1 + f@ )(1 + fh )(1 + f| )(1 + fV )(1 + fD )

Valuation using forward rates

The formula for valuation using forward rates will be:

Absolute yield spread = yield on bond X – yield on bond Y

A benchmark spread = a yield spread relative to a benchmark, e.g. to a Government bond.

discount rate = ¯bond value