Week 2

How would you find the The spot rates the coupon paying bonds can be derived from
spot rates on a coupon the ytm of zero- coupon bonds.
paying bond?

Can the YTM of coupon No because the yield to maturity will be different across
paying bonds be used to different coupons. However for example if you have a spots
price other coupon of up to 5 years you can price any coupon paying bonds up to
bonds? 5 years.

An example of arbitrage
3 ways for bonds

Construct a synthetic
bond that replicates the
cash flows of bond C
using bonds A and B

 X(A) shows the proportion of Bond A you need to buy

to replicate the cash flows in the first year.
For the example above You should buy bond C and replicate its cash flows using
should you buy or sell the bonds A and B
bond C?
Week 2

What will happen to the Bond traders will trade so that there will be an equilibrium in
above arbitrage the market where the price of the bond will equal to its
replicating portfolio. Bond C will trade so that it will equal the
price implied by bond B and A

Spot rates are important Spot rates are important because you have the ability to price
because they can help any bond in the market however the YTM on a coupon paying
price any bond in the bond is limited to pricing that coupon bond only.
market… how about the
YTM on coupon paying
bonds can these price
bonds in the market?
Important note When we infer interest rates we are at time 0 and with these
interest rates we can find future interest rates

How is equilibrium Through supply and demand the bond prices will change so
achieved when arbitrage that the bond and the replicating portfolio will continue be in
opportunity arises? equilibrium

Some notes: expected interest rate is what the market thinks the interest rate should be

Forward rate is what you as investor think it should be

Liquidity risk is when you come to sell your bond you wont get what you expected for it..
Week 2

Duration is the effective marutity of the bond but is also a measure of interest rate
sensitiveity of a bond

When you have lower coupons the weights on the earlier payments is reduced relative to
the final maturity payment (Final payment weight gets larger) therefore

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 the 2nd example shows that you get lower returns because you reinvest at lower
rate
 However when you sell you sell at higher price because of liquity risk
 Opposite for 3rd example

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 The reason bond A has liquidity risk is because its term does not match the liability’s
term hence you need to sell at before it matures

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 If you want to find out how many bonds you need to buy rather than how much in
dollars… you need to divide the dollar amount by the price of the bond