Debt, NPV, Interest rate,

Loans, Bonds, Arbitrage

1
 The Law of One Price and Arbitrage
• Law of One Price: If equivalent investment opportunities trade
simultaneously, then they must trade for the same price
• Otherwise, an arbitrage opportunity arises and exploiting it causes a
change in one of the prices until such an opportunity vanishes
• Arbitrage means buying and selling equivalent [including
financial] assets to take advantage of a price difference
• An arbitrage opportunity occurs when it is possible to make a
profit without taking any risk or making any investment
• At equilibrium, there cannot be arbitrage opportunities on
the financial market(s)

2
Present Value

• You can invest in a garage that pays $5,000 in three years.

• If you can generate a risk free 12% annual return on your
savings, what is the value of that investment today?
• If the return is 10%, does the interest in a garage become
more or less attractive?

3
The interest rate (or discount rate) and the present
value are inversely related; NPV: Net Present Value
•   5 000 $ ÷ (1,12)^3 = 3 558,90 $
• If the guaranteed return is 10%, the $5,000 amount is
worth today:
• 5 000 $ ÷ (1,10)^3 = 3 756,57 $
• so the second option is more interesting

 NPV = PV of all present and future cash flows, positive

(revenues) and negative (expenses)

4
 Inflation: an important rate,
influencing the discount rate
• Expected future inflation is important in determining the discount
rate a company's future earnings and estimating its present value.
• Authorities tend to underestimate official inflation because there
are many impacts; for example, the level of wages, electricity, gaz,
water prices, rents, insurance etc. are indexed to inflation.
• It is often deliberately underestimated in two ways:
• Quality effect: e.g. freezing an entry-level computer in 2000 rather
than comparing it with the entry-level today
• Housing effect: Content and weight of housing expenses: a.The
selling price of real estate is not taken into account (considered as
investment and not consumption), b.the rent, which does not
evolve as much, only counts for 7%.

5
 An example of arbitrage
A bond pays $1000 in one year, for sure. The risk- free interest rate is 5%:

• A.the price is $940. PV= 1000/(1 + 5%) = $952.38; arbitrage will force the price to rise until $952.38.
• B.the price is $960. PV= 1000/(1 + 5%) = $952.38; arbitrage will force the price to fall until $952.38.

6
 No-arbitrage and security prices
• If the price of the security is not equal to the PV of
the security’s cash flows, an arbitrage opportunity
appears, due to Law of One Price

• No Arbitrage Price of a Security:

Price(Security)  PV (All cash flows paid by the

security)
• Alternatively: NPV(trading security) = 0
7
Corporate debt, seniority
Total equity in the world: $80 trillion; total bonds: $66 trillion
In these 66, 20 are US govt bonds, 2,5 :French govt Bonds.
Out of these 66, 17 (25%) have a negative interest rate.
The majority of the bonds  in the world are sovereign.

4 types of Corporate debt:

• Secured: a. mortgage backed, property; b. asset backed,
• Unsecured: a. Notes (<10 years); b. Debentures (longer)

• Seniority: 3 categories of seniority, reimbursement

priority in case of bankruptcy: Senior, mezzanine, junior,
(the junior is subordinated to mezzanine, which is
subordinated to senior)
8
International versus Domestic Bonds,
TIPS: Treasury Inflated Protected Security
• Some countries issue bonds in foreign currency, (Argentina), for 2 reasons:
• 1. Investors want to be sure to be reimbursed in serious currency,
• Because if Argentina issues the bonds in domestic currency, in case of problem
government can easily print new money, devaluating their own currency, which
is not what international investors want to see.
• 2. Investors compliance rules. Some are not allowed to invest in currencies
other than euro or dollars, even if these other currencies are « serious ».
• TIPS pay coupons which amount is calculated yearly according to inflation
adjusted face value, not according to nominal face value 
• It is safer for the investor, because he’s protected against unexpected inflation,
therefore the yield is lower in this case; Besides, face value won’t decrease in
case of deflation
• Inflation protected bonds represent 5% of total bonds, 10% in France.
9
Other Financing sources
• Term loans
• Syndicated loans (with lead bank)
• Revolving line of credit
• Private placements
• Sovereign debt: Bills, Notes (2 to 10 years), Bonds 30
years or more, Inflation indexed – TIPS, Treasury
Inflation Protected Securities,
• Factoring
• Leasing
• Overdraft

10
 Bonds
• Contract between borrowers, corporate or sovereign, and lender
• Prospectus specifies the details such as the amount borrowed,
the interest (coupons) or zero coupons bonds, the maturity,
indenture (contract between issuer and trust company
representing bond holders).
• The bondholder is rewarded through:
• 1. Face value, or par value, or nominal value, (usually 1000$) is
paid by borrower (bond issuer) to lender (bond holder) at maturity
• 2. Coupons are paid regularly by bond issuer to bond holder,
annually, or semiannually, or other specified periods.
• To calculate the coupon amount: multiply the face value by the
coupon rate;  you get the annual figure, then divide it by 2 to get
the semi-annual coupon amount if it’s semiannual payment, or by 4
for a quarterly coupon amount, if it is quarterly 11
 Bonds
• T bills, Treasury bills, are U.S government (risk-free) bonds, they have less than 12
months maturity, are zero-coupon bonds
• They sell at a discount (a selling price lower than face value), so they are also
called pure discount bonds
• If a bond price is higher than face value, it is a premium bond
• Corporate bonds are usually semi annual coupon payment
• With maturity up to 30 years, except: examples: Walt Disney 100 years, issued in
1993, and in 2017 Austrian government bonds 100 years; Westphalia lander (in
Germany) issued 100 years maturity as well
• Face value is usually 1000 $, can be 100 $
• Municipalities and local regions (besides government) issue bonds as well
• Convertible bonds – can be converted into equity upon certain conditions
• Callable bonds – the issuer can reimburse the face value earlier than maturity,
upon certain conditions. This flexibility costs the issuer about 0,7%

12
Zero-coupon bonds
• A one-year, risk-free, zero-coupon bond with a
$100,000 face value has an initial price of
$96,618.36. The cash flows are:

• Although the bond pays no “interest,” your

compensation is the difference between the initial
price and the face value
13
Zero-coupon bonds
FV: Face value; n: number of periods; P: Price
• Yield to Maturity
• The discount rate that sets the present value of the
promised bond payment(s) equal to the current
market price of the bond.

• Price of a Zero-Coupon bond being P, then:

P*(1+YTM)^n=FV; 
F
P 
(1  VYTMn )n

14
Yield to Maturity (yield means « rendement »)
FV: Face value; n: number of periods; P: Price

• For the one-year zero coupon bond, the YTM is 3,5% :

• 96618 * (1+YTM)= 100000  1+YTM=100000/96618YTM=3,5%

• For n years zero coupon bond, the YTM is: (FV/P)^1/N - 1

15
Zero-coupon bonds: what’s the yield
• Suppose that the following zero-coupon bonds are selling at the prices
shown below per $100 face value. Determine the corresponding yield to
maturity for each bond

Maturity 1 year 2 years 3 years 4 years

Price $98.04 $95.18 $91.51 $87.14

A. 2%, 2.5%, 3.25%, 4%

B. 2%, 2.5%, 3.5%, 4%

C. 2%, 2.5%, 3%, 4%

D. 2%, 2.5%, 3%, 3.5%

16
Solution
• Solution: D

YTM  (100 / 98.04) 1  0.02  2%

YTM  (100 / 95.18)1/ 2 1  0.025 
2.5%
YTM  (100 / 91.51)1/3 1  0.03  3%
YTM  (100 / 87.14)1/ 4 1  0.035 
3.5%

17
Zero-coupon bonds: what’s the price
• Suppose the current zero-coupon yield curve for risk-
free bonds is as follows:
Maturity (years) 1 2 3 4 5
YTM 3.25% 3.50% 3.90% 4.25% 4.40%

• The price per $100 face value of a three-year, zero-coupon,

risk-free bond is closest to:

A) $93.80 C) $89.16

B) $90.06 D) $86.39
18
Solution
• Solution: C

• P * 1,039^3 = 100

==> $100/(1.039)3 = 89.1566

19
The Yield Curve and Discount Rates
• Term Structure: The relationship between the
investment term and the interest rate
• Yield Curve: A graph of the term structure

20
A More Recent Yield Curve…
US Treasury Yield Curve as of 2018−09−10
Source: Capital IQ

3.●09

3.●02

2.●94
2.●89
2.●83
2.8
2.●78
2.●73

Yield, %

2.●54

2.4

2.●32

2.●14

2.0
1.●98

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y

Maturity in months or years
21
A More Recent Yield Curve…
US Treasury Yield Curve as of 2019−08−26
Source: Capital IQ

2.●09

2.●04
2.●03
2.0
2.●01

1●.9

1.●84

1.8
Yield, %

1.●75

1.6

1.●54 1.●54

1.●49
1.●47

1.●43
1.4
1M 2M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y
Maturity in months or years
22
A More Recent Yield Curve…
US Treasury Yield Curve as of 2020−09−28
Source: Capital IQ

1.42

1.2

1.0

Yield, %

0.67

0.5
0.46

0.26

0.16
0.14
0.11 0.11 0.12
0.09 0.1

1M 2M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y

Maturity in months or years
23
 DEFINITIONS
PV= Present Value; C= Coupon; n= Number of periods; R= Rate (interest rate):

•Perpetuity: C
PV (C in perpetuity) 
r
same amount paid regularly forever: what is it worth
C
PV (growing perpetuity) 
•Growing perpetuity: r g
amount growing regularly & constantly at growth rate g

•Annuity: like perpetuity, but not forever, for a limited number of periods,
n
PV= C/R *(1-(1/1+R)^n);  C = (R * PV) / (1 - 1 / (1 + R)^ n)
1  1g  
N

PV  C  1    
•Growing Annuity: 
(r  g )   (1  r )  
amount growing regularly & constantly at growth rate g

24
Perpetuity and growing perpetuity examples
• The Nobel prize was created in 1901 to make people forget its inventor's past.
• Alfred Nobel decided to give 6 Nobel prizes per year (medicine, economics, chemistry, physics,
literature, peace)
• Each recipient ("laureate") receives a gold medal, a diploma, and a monetary award: 1 M$ each
• Interest rate guaranteed by Svenska Handelsblatt, the Swedish bank: of 5%
• Alfred Nobel had to calculate how much he needed to invest in the bank in order to guarantee these
prizes forever
• He did a perpetuity calculation: PV= C/R= 6/5%= 120 M$
• If Nobel wants the prize to grow by 2% annually, then it’s a growing perpetuity: PV= C/(R-G)= 6/(5%-
2%)= 200 M$

25
 • Formule de l’annuité:

P 80,000
C   7,106.19
1 1  1  1 
1  
N 
1  
30 
r  (1  r )  0.08  (1  0.08) 

26
Outstanding (in French: Encours)
• Now let's assume that after 15 years, the company sells
the warehouse for $120,000
• The asset is sold, the loan must be repaid to the bank
• How much do you owe the bank after 15 years?
• Naive estimate: 80,000/2 = 40,000 yes but no...
• You owe $60,824
7,106  1 
Outstanding Loan Balance  1    $60,824
15 
8%  1  8%  

27
Interests, reimbursements, outstanding
• When the loan payment exceeds the interest due on the remaining
balance, the "overpayment" is a repayment of principal
• For example, for a loan of $80,000 with an EAR (Effective Annual Rate, in
French TAEG – Taux Annuel Effectif Global) = 8% and annual payments, you
would pay the first year: 8% x $80,000 = $6,400 in interest
• But the annual payment is $7,106
• 7,106 - $6,400 = $706 of the first annual payment is a first repayment of
the $80,000 loan.
28
Interests, reimbursements, outstanding
• The following year, the initial balance will be $80,000 - $706 = $79,294.
• Interest due will be: $79,294 x 8% = $6,343.5
• The remaining part of the payment will therefore constitute a
repayment of the principal equal to:
• 7 106 $ - 6 343,5 $ = 762,5 $
• Although the annual payment remains constant, its composition varies
and the principal repayment increases, as shown in the following slide

29
Interests, reimbursements, outstanding

30
Coupon bonds
• Pay face value (usually 1000$, or 100$) at maturity

• Pay regular coupon (interest payments), at the

end of every period, mostly annual, or semi-
annual
• Risk-free: US Treasury ($-denominated), German
Bund (EUR-denominated)
• Risky: other sovereign bonds, corporate bonds

31
Coupon bonds: an example
• The U.S. Treasury has just issued a ten-year,
$1000 bond with a 4% coupon and semi-
annual coupon payments.
• What cash flows will you receive if you
hold the bond until maturity?

To calculate the coupon amount: multiply the face

value by the coupon rate;  you get the annual
figure, then divide it by 2 to get the semi-annual
coupon amount, if semiannual coupon payment is
specified, or by 4 for a quarterly coupon amount

32
Coupon bonds: an example
• The face value (called also par value) of this bond is $1000

• Because this bond pays coupons semiannually, you will

receive a coupon payment every six months of $1000 X
4%/2 = $20

• The last payment occurs ten years (twenty six-month

periods) from now and is composed of both a coupon
payment of $20 and the face value payment of $1000
33
Coupon bonds: the price?
• The price of a coupon paying bond if we have the YTM
paid by the bond? « actualize » the bond cashflows:
• Annuity of the coupons + PV of the Face Value
• The YTM is the SINGLE discount rate that equates the
present value of the bond’s remaining cash flows to its
current price

1  FV
P  CPN  1 1  N 


y  (1  y)  (1  y) N

34
Replicating a coupon bond
Finding the price of a coupon bond without having the
YTM paid by the bond: the law of one price

• Replicating a three-year $1000 bond paying 10%

annual coupon using 3 zero-coupon bonds:

35
Replicating a coupon bond: 3 years
coupon bond is like a portfolio of zero coupon
bonds: 1 of 1 year, 1 of 2 years, 11 of 3 years

• By the Law of One Price, the three-year coupon bond is

equivalent to the following portfolio of zero coupon bonds,
giving same cashflows it must trade for a price of $1153
• Yields and Prices (per $100 Face Value) for Zero Coupon
Bonds in the following table (YTM aren’t really necessary)

36
Interest rate changes and bond
prices
• The YTM is the rate you effectively earn when you invest
in a bond
• The coupon rate is the rate the bond pays on its face
value
• The coupon is paid at the end of each period, while the
face value is paid at maturity
• In case of TIPS (inflation protected), the face value is
adjusted according to inflation
• However, face value won’t decrease in case of deflation
• You can consider zero coupon bonds as if it were
coupon bond with coupon rate of 0%

37
Semi annual coupon bond

The Danome Company has a bond outstanding with

a face value of $1,000 that reaches maturity in 15
years. The bond certificate indicates that the stated
coupon rate for this bond is 8% and that the
coupon payments are to be made semiannually.

A) What’s the amount of every semi-annual

coupon payments?

B) What price will the bond trade for if YTM is

7.5%?
38
Solution

A) Coupon =
(coupon rate x face value) / number of coupons per
year = (8% × 1,000) / 2
= $40

B) Price =
$40 / 0.0375 * (1-1/(1.0375)^30)+1,000/(1.0375)^30 =
$1044.57

39
Finding the price through zero coupon bonds

Maturity 1 2 3 4 5
Zero-Coupon YTM 3.25% 3.50% 3.90% 4.25% 4.40%

A two-year default free security with a face

value of $1,000 and an annual coupon rate
of 5% would be traded at which price:

A) $1002.78 B)
$1003.31

C) $1028.50 D) 40
Solution: D
• The cash flows are:
• 1st year: 50,
• 2nd year: 1050 (composed of face value of
1000 + 50 which is the coupon of second year)

Price = $50/(1.0325)1 + (50 + 1,000)/(1.035)2 =

= $1,028.61

41
APR : Annual Percentage Rate;
versus EAR : Effective annual rate
(which is in French TAEG – Taux Annuel Effectif Global)
The difference is the compounding effect

Example: suppose a semiannual rate of 4%; what

is the corresponding annual rate?

In terms of EAR: (1+4%)^2=1,0816

 = 8,16%
Expressed as an APR with semiannual
compounding : 4%*2
 =8%
42
APR

Suppose a five-year bond with a 7% coupon

rate and semiannual compounding is trading
for a price of $951.58. Expressed as an APR
with semiannual compounding, this bonds
yield to maturity (YTM) is closest to:
A) 7.0% C) 7.8%

B) 8.2% D) 7.5%

43
Solution
• Solution: B
• 951.58 = 35/y × (1−1/(1+y)10)+1000/(1+y)10

• Coupon = 35, Face Value = 1000, PV = 951.58, N

= 10,

• Compute y = 4.099949

• YTM (annual) = y x 2 = 8.199898%

44
Corporate bonds and the risk of default
• Bonds issued by a corporation

• Investors pay less for bonds with credit

risk than they would for an otherwise
identical default-free bond
• In other words, the yield of bonds with credit
risk will be higher than that of otherwise
identical default- free bonds

45
Corporate bond yields
• No Default
• Consider a 1-year, zero coupon US Treasury Bill
(considered safe) with a YTM of 4% and a face
value of $1000.
• What is the price?

1000 1000
P    $961.54
1  YTM1
1.04
• Since the $1000 are certain, 4% is also the risk free rate
46
Corporate bonds yields
• Certain default: 100% chance the bond will default
and return $900

• The $100 lost is called the loss given default

(equivalent to 90% recovery rate)

• Although the bond defaults, the default is certain,

hence $900 are certain money

• P = 900 / 1.04 = $865.38

• YTM = 1000 / 865.38 - 1 = = 0.1556 = 15.56%

• YTM is calculated according to best case scenario 47

Corporate bond yields
• Risk of Default
• Consider a one-year, $1000, zero-coupon bond
issued. Assume that the bond payoffs are
uncertain
• There is a 50% chance that the bond will repay its face
value in full and a 50% chance that the bond will default
and you will receive $900. Thus, you would expect to
receive $950

• Because of the uncertainty, the discount rate is 5.1%

48
Corporate bond yields
• Risk of Default
• The price of the bond will be
950
P  
1.051 $903.90
• The yield to maturity (according to best case
scenario) will be
FV 1000
YTM   1   1  .1063
P 903.90

49
Corporate bond yields
• The 10.63% promised yield is the most investors
will receive
• If the bond defaults investors receive:
900/903.90
– 1 = -0.43%
• If the bond does not default investors receive:
1000/903.90 – 1 = 10.63%
• The average return:
• 10.63% * 0.5 + (-0.43%) * 0.5 = 5.1%!
50
Corporate bond yields
• Risk of Default
• A bond’s coupon rate will be less than the yield to
maturity if there is a risk of default.

• Why?

• The bond investors (=buyers) require a higher YTM

to buy and hold the bond
• This higher YTM corresponds to the return they ask to
hold a financial asset with the same risk as the bond

51
Risky bonds
• IE-Ways a newly-founded company that specializes on the
simulation of race car-driving, issues a one-year zero
coupon bond with a face value of $1,000. Investors
estimate the chance that the company will survive the first
year at 60%. In case of default, the investors expect only
$500

• What do you expect to receive after 1 year?

• Given a discount rate of 8%, what is the price of the bond?

• What is the yield to maturity?

52
Solution
• Expected payoff at year end:

0.6 x $1,000 + 0.4 x $500 =

$800
• The price of the bond
800 will be:
P  
1.08 $740.74
• The YTM is:
FV 1000
YTM  1   1  .3500
P 740.74
 53
Triple B bond
• Wyatt Oil is contemplating issuing a 20-year bond with semiannual coupons, a
coupon rate of 7%, and a face value of $1000. Wyatt Oil believes it can get a BBB
rating from Standard and Poor's for this bond issue (see the Table)
Security Term (years) Yield (%)
Treasury 20 5.5%
AAA Corporate 20 7.0%
BBB Corporate 20 8.0%
B Corporate 20 9.6%

• If Wyatt Oil is successful in getting a BBB rating, then the issue price for these
bonds would be closest to:

A) $800 B) $891

C) $901 D) $1,000

54
Solution
• Solution: C

• FV = 1000, N = 40, interest rate (semester)

= 4%, CPN = 35, Compute PV!

PV =

(35/0.04) x
(1−(1/(1+0.04)40)+(1000/(1+0.04)40)

 Price = PV = 901.04
55
Bond rating
• The easiest way to price a bond is to discount the promised
cash flows by the YTM for this (particular) bond

• So far we performed this by defining the price first via

• the opportunity cost

• the default probability and

• the recovery rate

• But in the reality neither of these is easy to obtain, hence

specialized institutions (rating agencies) do it for classes
of default risk,
56
Bond ratings
Yield curves
• There are corporate yield curves and
sovereign yield curves
• Credit Spread (or Default Spread):
• The difference between the yield on the bond and
the US Treasury yield which is risk free

58
Corporate yield curves as of Sept. 3rd, 2018

Source: Capital IQ

59
Corporate bonds yield
spreads
 Arbitrage Example
Between 2 investment strategies

Strategy A:
- Renault bond: zero coupon, maturity: 1 year,
- Valeo bond: zero coupon, maturity: 2 years
- Purchase price: $900 in both cases
- Par value (face value): $1000 
Strategy B:
- Ford Bond:
- 10% coupon rate, maturity 2 years, par value: $1000,
purchase price: $1125
Compare the 2 strategies using the same cashflow:
1000 $ first year and 11000$ second year
• YEAR 1: By investing in one Renault bond we have 1000$, at
the end of the 1st year,  so we have to buy 10 Ford to
have 1000$ (10 coupons) as well at the end of the 1st year
• YEAR 2: the 10 Ford bonds, bring $11,000 in year 2: 10
coupons, which is 1000$ + 10 face values, which is 10000$
• YEAR 2: So, for having equivalent cashflows from strategy A:
we have to buy 11 Valeo in order to get $11,000 as well
• Strategy A costs: 1 Renault + 11 Valeo : 12 * 900 = $10,800;
Strategy B costs: 10 Ford : $1,125 *10 = 11,250
• For the same cashflow Strategy A is less expensive by $450
• So, there is an arbitrage opportunity!
Arbitrage: other scenarios
• If the price of 900 (purchase price) changes, will arbitrage be
impacted? How will it be impacted?
• If Ford's coupon rate changes, will arbitrage be impacted?
How will it be impacted?
• If the maturity of the Ford bond is 3 years, instead of 2
years, will arbitrage be impacted? How will it be impacted?
• What should we look for in order to execute an arbitrage in
the latter case?
Arbitrage: the coupon rate of Ford coupon rate
changes, will arbitrage be impacted? How?
• The more the coupon rate increases, the less interesting the
arbitrage is.
• The Ford coupon rate balance point, or break even point, for
a no arbitrage situation (so that one is indifferent between
the two strategies) is 12.5%
• Explanation: x being the number of Ford’s bonds, the
following equation is necessary for a non arbitrage situation:
• 900*(2+X)=1125*X  x = 8; we need 8 Ford bonds to
balance the face value of one Renault bond in year 1
• Which means that the coupon rate is 12.5% (explanation:
1000/8=125, meaning that the coupon rate is 12,5%)
FOREX & interest rate
• The exchange rate between the U.S. dollar and the
euro is $1.35 per euro.
• You can invest at an annual interest rate of 3% in
dollars, while the interest rate in euros is 2% per
year.
• What should the dollar-euro exchange rate be in a
year that makes you indifferent between investing
in dollars and investing in euros today?

65
Solution A
• If you don't change the exchange rate everyone would be investing in
dollars.
• Therefore, you need to strengthen the euro. By how much? The
interest rate differential, e.g. 1.03/1.02
• Therefore, divide 1.35 by 1.02 and multiply by 1.03.
• 1,35 / 1,02 * 1,03 = 1,363

66
Solution B

• Today you are indifferent between 1 € and 1.35 $.

• Tomorrow you should be indifferent between 1.02 € and
1.3905 $ (which is 1.35 * 1.03)
• Therefore, 1.3905 / 1.02 = 1.363 is the rate that will leave
you indifferent between the two alternatives.

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Cross Currency Base Factor
In favor of the U.S. dollar,

• 80% of the world's transactions take place in US dollars

• So this currency is very important and useful: it is more
useful to have a US$ rather than a € and then have to go to
the exchange office; this has a value
• Which is estimated to be 10 basis points (100 basis points =
1%).
• And must be taken into account including in the evaluation
of companies
• The rate 1.363 becomes 1.364, thus strengthening the euro

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