Week 1 Precept

Fixed Income, Options and Derivatives: Models and

Applications

Yinjie Yu

Department of Economics & Bendheim Center for Finance

Princeton University

January 31, 2024

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Logistics

Precept
▶ Every Tuesday at JRRB 101 (12:30-1:20 pm/7:30-8:20 pm) in person.
▶ Slides will be posted on Canvas after each precept.
▶ Review, prepare you for homework, and cover complementary materials.

Preceptor Information
▶ 3rd year Ph.D. candidate in Economics (Field: Macro and Finance)
▶ Email: yy1457@princeton.edu
▶ Office hours: Thursdays 3:00-4:30pm at Bendheim Center for Finance (JRRB) A03

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Overview

1. Fixed income basics

2. Duration and Convexity

3. Yield curve

4. Excel tutorial

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Discounting and compounding
Consider a zero coupon bond
1 1
B(t, T ) = ′
=
1 + R (t, T ) (1 + R(t, T ))T −t

▶ R’(t,T) is the non-annualized return from t to T.

▶ R(t,T) is the annualized spot rate.

Compounding happens when interest paid is reinvested to earn more interest.

▶ For example, if the bond is compounded semi-annually.
1
B(t, T ) =
(1 + R2 (t, T )/2)2(T −t)
▶ One can prove that R2 < R.
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Coupon bond

Consider a coupon bond with face value 1 that matures in T years and pays
coupon annually at rate c.

Coupon bond could be viewed as a collection of zero coupon bonds.

T T
c 1
B(0, T, c) = ∑ + = ∑ cB(0, t) + B(0, T )
t =1
(1 + R t ) t (1 + R T ) T t =1

Example.

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Yield to maturity

YTM is in a sense the average of spot rate of all periods that the bond pays cash
flows.
T T
c 1 c 1
B(0, T, c) = ∑ t
+ T
=∑ t
+
t =1
(1 + R t ) (1 + R T ) t =1
(1 + RYTM ) (1 + RYTM )T

Example: B(0,1) = 0.9, B(0,2) = 0.8, what is the YTM of B(0,2,0.1)?

Prove that bond is issued at par if coupon rate is the same as YTM.

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Overview

1. Fixed income basics

2. Duration and Convexity

3. Yield curve

4. Excel tutorial

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Definition
(Macaulay) Duration is the weighted (cash flow’s present value) average time to
receive all the cash flows from the bond.

For a zero coupon bond with YTM R and maturity T (suppose face value is 1):
B = (1 + R ) − T , D := T
For a bond with coupon rate c:
T T
c 1
B=∑ t
+ , D := ∑ t · wt
t =1
(1 + R ) (1 + R ) T t =1

▶ the cash flow weights add up to 1 according to the bond price formula
1 c 1 c+1
wi = ( i ≤ T − 1), wT =
B (1 + R ) i B (1 + R ) T
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Definition

Prove the following holds for coupon bond

(1 + R) ∂B
D=−
B ∂ (1 + R )

Duration is also the percentage change in B given 1% change in (1+R).

Question: does it still hold if the bond is compounded continuously?

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Definition
Duration also captures the sensitivity of bond price to yield change.
▶ Modified Duration and Convexity

1 ∂B 1 ∂2 B
Dm = − , Cm =
B ∂R B ∂R2
▶ Derive from Taylor Expansion

∆B 1 ∂2 B
 
1 dB
= ∆R + (∆R) + o (∆R )
2 3
B B dR 2 ∂R2
1
= − Dm ∆R + Cm (∆R)2 + o (∆R3 )
2
▶ Can you derive Dm and Cm for a zero coupon bond? How about one that’s
continuously compounded?

Dm and D converge as compounding frequency increases.

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Properties of duration

For a bond with coupon rate c, compounded semi-annually:

" #
2T
c/2 1 1 2T t · c/2 2T
B=∑ t
+ 2T
, D= ∑ (1 + R/2)t + (1 + R/2)2T
t =1
( 1 + R/2 ) ( 1 + R/2 ) B t =1

What happens to a coupon bond’s duration when

▶ the coupon rate c increases?
▶ the bond’s yield to maturity R increases?
▶ the bond’s maturity T increases?

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Properties of convexity

For a bond with coupon rate c, compounded semi-annually:

2T  
1 1
Cm =
(1 + R/2)2 ∑ wt t t + 2
t =1

where wt are cash flow weights that add up to 1

What happens to a coupon bond’s convexity when

▶ the coupon rate c increases?
▶ the bond’s yield to maturity R increases?
▶ the bond’s maturity T increases?

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How good is the Approximation?

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Overview

1. Fixed income basics

2. Duration and Convexity

3. Yield curve

4. Excel tutorial

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Yield curve and duration hedging

The difference between the spot rate TS and yield curve.

▶ Yield curve is constructed based on coupon bonds.
▶ Question: given a upward sloping YC, is the SR TS lower or higher than the YC?

Questions: are the following statements true, if the market is arbitrage-free,

▶ Two bonds that have the same maturity must have the same YTM
▶ Two bonds that have the same duration must have the same YTM

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Yield curve and duration hedging
How does the yield curve change map into the YTM change of a specific bond?

Recall the definition of YTM:

T T
Ci C
∑ (1 + RYTM )i ∑ (1 + iRi )i
=
i =1 i =1

In duration hedging we have

∆B
≈ Dm ∆RYTM + Cm (∆RYTM )2
B
Can we, for example, take ∆RYTM = R D ?

We have assumed a uniform change of the yield curve, but risk management using
duration and convexity fails fatally when the slope of yield curve changes.
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Is term structure flat in reality

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Overview

1. Fixed income basics

2. Duration and Convexity

3. Yield curve

4. Excel tutorial

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The “PV” function

PV(rate,nper,pmt,fv)
Rate is the interest rate per period.
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period and cannot change over the life of the
annuity.
Fv is the future value, or a cash balance you want to attain after the last payment
is made.

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The “RATE” function

RATE(nper,pmt,pv,fv,type,guess)
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period and cannot change over the life of the
annuity.
Pv is the present value.
Fv is the future value, or a cash balance you want to attain after the last payment
is made.

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The “ACCRINT” function

ACCRINT(issue, first interest, settlement, rate, par, freq,[basis],[calc method])

issue is the date of the previous payment.
first interest is the next coupon date.
settlement is the date when the transaction is settled.
rate is the coupon rate.
par is the face value of the bond.
freq is the frequency of coupon payment.
basis is the type of day count basis to use. 1 = Actual/actual.

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How to load the ”Solver” in Excel

Two useful links:

For Windows: goo.gl/j0PAvG
For Mac: goo.gl/6zZpwy

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