Fixed Income

Felix Matthys

Lecture 2: Basic Fixed Income Analysis

Outline

1 Time Value of Money and Present Value

2 Bond Pricing

3 Yield To Maturity

4 Extracting the Zero-Coupon Discount Curve

5 Day Count Conventions

6 Accrued Interest

7 Floating Rate Bonds

Felix Matthys Fixed Income ITAM 2 / 90

Time Value of Money and Present Value
Time Value of Money
A dollar today is worth more than a dollar tomorrow.

Explanations:
• Having money today gives you the opportunity to invest it and earn a risk free rate or
consuming goods and services.
• Furthermore, the purchasing power of your money can decline if price level rises in the
future.

Definition: Present Value (PV)

The present value of a future payment is that amount which, when invested today at a given
interest rate, would result in the given value to the future payment.

• Want criteria to choose today from two different future payments, in other words we are
interested in transforming the future payments, which may be deterministic or random
into a value today.
• This is done through a discount factor Z . We have

PV = FV × Z

where FV is the future value.

Felix Matthys Fixed Income ITAM 3 / 90
Present Value (example)
• The present value PV (0) is obtained as:
FV
PV (0) =
1+r
• The future payoff amount FV is discounted, since the present value is less than
the future payment FV . The factor
1
Z =
1+r
by which we multiply the future payoff value is called the discount factor
• The previous discussion may be extended to a stream of several payments or cash
flow.
• Consider time interval [0, T ] consisting of T equally spaced periods, with interest
rate r per period
• Receive payment C0 at time zero, invest in the bank; receive C1 at time 1 and
invest it in the bank, (...) until time T , when we receive CT .
• The future value of the cash flow is (compounded every period):

P(T ) = P0 (1 + r )m + P1 (1 + r )m−1 + P2 (1 + r )m−2 + ... + Pm

Felix Matthys Fixed Income ITAM 4 / 90

Present and Future Values of Cash Flows (cont’d)

• Similarly, given a cash flow of payments with values C0 , ..., Cm , where Ci is the
payment at the end of the ith period, the present value of the cash flow is
(compounded every period):
T
C1 C2 Ct X Ct
PV (0) = C0 + + 2
+ ... + t
=
(1 + r ) (1 + r ) (1 + r ) t=1
(1 + r )t

• It can be checked that the present value PV and the future value FV (T ) are
related by:
FV (T )
PV =
(1 + r )t

Felix Matthys Fixed Income ITAM 5 / 90

Discount Factor

Discount Factor (informal definition)

The discount factor Z (t, T ) between two dates t and T , where 0 ≤ t ≤ T determines the value
today at time t of a future payment at T

Example: On Monday, the 12th of January 2016 (= t) the discount factor was
Z (t, T ) = 0.999825 (mid quote) with payment of $ 1 on February 15th (= T ) which implies a
(annual) interest rate of 0.1936%.1

No Arbitrage Condition
For any time t ≥ 0, and let T1 < T2 and assume that the nominal interest rate r be positive,
then we must have that
Z (t, T2 ) ≤ Z (t, T1 ), ∀t ∈ [0, T1 ]

1
To compute this interest rate, we use expression (2), and invert it to obtain the
continuously compounded interest rate r (t, T ) = − τ1 ln (Z (t, T )), where τ = 33/365.
Felix Matthys Fixed Income ITAM 6 / 90
Compounding Frequency

Definition: Discount Factor

Let rn (t, T ) be the annualized n times compounded interest rate over the time T − t,
then the discount factor Z (t, T ; n, rn ) := Z (t, T ) is defined as
1
Z (t, T ) =  n(T −t) (1)
rn (t,T )
1+ n

where n ∈ N. In the limit, when n → ∞ we obtain the continuously interest rate

r∞ (t, T ) = r (t, T ) from solving

Z (t, T ) = e −r (t,T )(T −t) (2)

for r (t, T ).

• Two important compounding frequencies: Semi-annual and Continuous.

Felix Matthys Fixed Income ITAM 7 / 90

Compounding Frequency: Example

• We let r2 (t, T ) denote the (annualized) semi-annually compounded interest rate

!
1
r2 (t, T ) = 2 1 −1
Z (t, T ) 2×(T −t)

• If the discount is Z (t, T ) =0.98 and maturity T − t = 1 is one year. The

semi-annuual interest rate is r2 (t, T ) = 0.0203.
• If I have $9.8 m, and I invest it in a security with semi-annual compounding
r2 (t, T ) = 0.0203, I will have $10 m in one year.
   
r2 (t, T ) r2 (t, T )
$9.8 m × 1 + × 1+ = $10
2 2

Felix Matthys Fixed Income ITAM 8 / 90

Impact of Compounding
When we compound n times per year at rate rn (t, t + 1) an amount K grows to
K (1 + rn (t, t + 1)/n)n in one year

Compounding frequency Value of $100 in one year at rn (t, t + 1) = 10%

Annual (n=1) 110.00

Semiannual (n=2) 110.25

Quarterly (n=4) 110.38

Monthly (n=12) 110.47

Weekly (n=52) 110.51

Daily (n=365) 110.52

Hourly (n=8’760) 110.52

Continuous (n = ∞) 110.52
Felix Matthys Fixed Income ITAM 9 / 90
Relationship between Discount Factors & Interest Rates

Conversion Formulas
Given the interest rn (t, T ) with n times compounding frequency, the continuously
compounded interest rate r (t, T ) satisfies
1
e −r (t,T )(T −t) = Z (t, T ) =  n(T −t) (3)
rn (t,T )
1+ n

and thus we obtain

 
rn (t, T )
r (t, T ) = n ln 1 +
n
 
r (t,T )/n
rn (t, T ) = n e −1

Felix Matthys Fixed Income ITAM 10 / 90

 Term Structure of Interest Rates over Time
10
3M
1Y
8 5Y
10Y
6

0
1990 2000 2010

Figure: Panel A: Yield curve. Source: U.S. Department of the Treasury. Panel B: Yield Curve
evolution over time. Source: Federal Reserve Board.

Felix Matthys Fixed Income ITAM 11 / 90

Term Structure of Interest Rates
Definition: Term Structure of Interest Rate
The term structure of Interest Rates (yield curve, spot rate curve) at a given time t
defines the relationship between the level of interest rates r (t, T ) and their time to
maturity τ = T − t.

Definition: The Slope of the term structure

The slope (term spread) is the difference between the long - term rates (e.g. the 10 year
rate) and the short - term rates (e.g. 3 months rate).

• Term spread is usually positive

• Depends on numerous economic variables:
1 Expected future inflation
2 Expected future growth of the economy
3 Risk appetite of investors

Felix Matthys Fixed Income ITAM 12 / 90

Pricing of Zero - Coupon Bonds

Definition: Zero Coupon Bond

A zero coupon bond is a bond with no intermediate cash flows between the issue date
and maturity. More formally, the zero coupon bond at time t with maturity T is given by

Pz (t, T ) = N × Z (t, T )

where N is the face, principal, amount or par value which usually is $100.
Note: Subscript z refers to ”zero coupon bond”.

Felix Matthys Fixed Income ITAM 13 / 90

Pricing of Coupon Bonds

Definition: Coupon Bond

The price of a coupon bond at time t paying an annual coupon rate c with maturity T
and with n payments per year on dates T1 , T2 , . . . , Tm = T is denoted by Pc (t, T ).a
The price of the coupon bond is given by
m
! m
cX cX
Pc (t, Tm ) = N Z (t, Ti ) + Z (t, Tm ) = Pz (t, Ti ) + Pz (t, Tm ) (4)
n i=1 n i=1

where Z (t, Ti ) denotes the discount factor for each payment date i and
m = ⌊(T − t) × n⌋ is the total number of coupon payments over the lifetime of the
bond.b
a
We will use the convention that the last payment date Tm is just T , which is equal to the maturity of the bond
b
Note: The operator ⌊·⌋ simply rounds any number down to its closest integer. Example: ⌊2.4⌋ = 2 or ⌊2.9⌋ = 2

Observe: Equation (4) shows that the price of a coupon bearing bond can be expressed
as a sum of zero-coupon bonds.

Felix Matthys Fixed Income ITAM 14 / 90

Exercise (Coupon Bond Pricing)
Consider a US Treasury note with the following characteristics
Issue date: January 3rd, 2006
Maturity: 2 Years
Payment Frequency: semi-annually
Coupon payment rate: 4.375 %
Face value N = $100
Discount factors: Z (t, t + 0.5) = 0.97682, Z (t, t + 1) = 0.95718,
Z (t, t + 1.5) = 0.936826, Z (t, t + 2) = 0.91707

What is the price of the bond at time t?

Felix Matthys Fixed Income ITAM 15 / 90

Exercise (Coupon Bond Pricing)
Consider a US Treasury note with the following characteristics
Issue date: January 3rd, 2006
Maturity: 2 Years
Payment Frequency: semi-annually
Coupon payment rate: 4.375 %
Face value N = $100
Discount factors: Z (t, t + 0.5) = 0.97682, Z (t, t + 1) = 0.95718,
Z (t, t + 1.5) = 0.936826, Z (t, t + 2) = 0.91707

What is the price of the bond at time t?

Felix Matthys Fixed Income ITAM 15 / 90

No Arbitrage Pricing

Suppose that Equation (4) does not hold, i.e.

m
cX
Pc (t, T ) < Pz (t, Ti ) + Pz (t, Tm )
n i=1

and that coupons are paid semi-annually, i.e. n = 2. Why is this an arbitrage?
• At time t, buy bond Pc (t, T ) and sell c/2 × N units of zero coupon bonds with
maturities Ti , i = 1, 2, . . . , m − 1 and (1 + c/2) units of a zero coupon bond with
maturity Tn = T .
• Payoff: ∆ = nc m
P
i=1 Pz (t, Ti ) + Pz (t, T ) − Pc (t, T ) > 0

• For every coupon payment date Ti , the arbitrageur obtains a coupon c/2 and has
to deliver exactly −c/2 treasuries to the investor. Thus the trader is fully hedged.

Felix Matthys Fixed Income ITAM 16 / 90

No Arbitrage and Replicating Portfolios

An important observation
• The bond pricing Equation (4) reveals that, a coupon paying bond, can be
interpreted as a portfolios of zero coupon bonds (discount factors), i.e.
securities with just a single payment at maturity.
• Thus, once we have obtained the zero coupon bonds, we can price any other
security.
• Furthermore, given a coupon paying bond, we can exactly replicate its payoff
profile by taking positions in a set of zero coupon bonds.
• Since the two securities, i.e. the coupon bond and the portfolio of zero coupon
bonds have identical payoff profiles (payment amounts are the same and they
occur at the same time), their price, by the law of one price, has to be the same.
Otherwise there exists an arbitrage opportunity.

Felix Matthys Fixed Income ITAM 17 / 90

No Arbitrage and Replicating Portfolios
Suppose we have the following traded bonds

Bond Coupon Maturity Price

Bond 1 1 1/4 % 11/30/2010 100.550

Bond 2 4 7/8 % 5/31/2011 104.513

Bond 3 4 1/2 % 11/30/2011 105.856

Bond 4 3/4 % 11/30/2011 100.190

where coupon payment frequency is semi-annually.

• It turns out, that the 3/4% bond is too ”cheap” or miss-priced. Thus there exists
an arbitrage opportunity?
• Observe that we have a bond for each maturity Bond 4 is paying a coupon.
• Thus, for each maturity, we can compute the implied discount factor Z (t, T )

Felix Matthys Fixed Income ITAM 18 / 90

Example: Deriving Replicating Portfolios

How do we exploit this arbitrage opportunity?

• The arbitrage trade is: To buy the under-priced Bond 4 and simultaneously sell (or
short) a portfolio consisting of bond 1,2 and 3.

Questions is: What are the bond holdings?

• To replicate the 43 s of November 30, 2011, we use the 1 21 s due Nov. 30, 2010, the
4 87 s due May 31,2011, and the 4 21 s due Nov. 30, 2011
• Number these bonds 1, 2, and 3, and let θi be the face amount of bond i in the
replacing portfolio.
• The following equations show the requirement that the cash flows of the
replicating portfolio equal those of the 34 s on each of the three cash flow dates.

Felix Matthys Fixed Income ITAM 19 / 90

 • cash flow of Nov. 30, 2010
! ! !
11% 1 4 78 % 2 4 12 % 3
%
100% + 4 θ + θ + θ3 = 4
2 2 2 2

• cash flow of May 30, 2011

! !
1 47% 2 4 12 % 3
%
0×θ + 100% + 8 θ + θ3 = 4
2 2 2

• cash flow of Nov. 30, 2011

!
1 2 41% 3
%
0×θ +0×θ + 100% + 2 θ3 = 1 + 4
2 2

Replicating portfolios are easier to describe and manipulate using matrix algebra
    
1.25% 4.875% 4.5% 1 0.75%
 1+ 2 2 2  θ   2 
    
    
 0 1+ 4.875% 4.5%   θ2  =  0.75% 
 2 2    2 
    
    
0 0 1+ 4.5%
2
θ3 1 + 0.75%
2

which can be easily solved by pre-multiplying each side by the inverse of the cash flow
matrix.
Felix Matthys Fixed Income ITAM 20 / 90
Determining Replicating Portfolio Weights
We have a system of three equations and three unknowns. Thus there exists a unique
solution to the portfolio holdings θi , i = 1, 2, 3
• The equations can be solved one-at-a-time, since one bond matures on each date

θ1 = −1.779%
θ2 = −1.790%
θ3 = 98.166%

• In other words, we are taking a short position in bond 1 of θ1 = −1.779 whose

payoff is 100.625 (principal and coupon of 1.25%) on November 30, 2010,
produces a cash outflow of −1.779% × 100.625 = −1.790.
• Similarly, the short position in bond 2 of θ2 = −1.790 will lead to a cash outflow
of −0.04875/2 × 1.79 = −0.44% on November 30, 2010 and to an cash outflow of
−(1 + 0.04875/2) × 1.79% = −1.834 on May 31, 2011
• Finally, the long position in bond 3 will lead to the following cash inflows
1 98.166 × 0.045/2 = 2.209 on November 30, 2010 and May 31, 2011.
2 98.166 × (1 + 0.045/2) = 100.3747 on November 30, 2011.

Felix Matthys Fixed Income ITAM 21 / 90

Costs and Profits of this Replicating Strategy

What are the costs associated with setting up this arbitrage opportunity?
1 Bond 1: −100.55 × 0.01779 = −1.789
2 Bond 2: −104.513 × 0.0179 = −1.871
3 Bond 3: 0.98166 × 105.856 = 103.915

Therefore the total costs of the replicating portfolio are 100.255 which is higher than the
price of bond 4 (100.190). Since they both deliver the same payoff for each of the three
maturities, there exists an arbitrage opportunity.

• An arbitrageur could buy 100 face amount of the 3/4% coupon bond for $100.19
and sell the replicating portfolio for $ 100.255 looking in an immediate profit of
0.065 per unit or 6.5 cents.
• If the arbitrageur scales up the trade to $ 1 Billion face value, the riskless profit is
$ 650’000.

Felix Matthys Fixed Income ITAM 22 / 90

Table: The replicating portfolio of the 34 s of November 30, 2011, with prices as of
May 28, 2010

(1) (2) (3) (4) (5) (6)

(i) coupon 1 41 s 4 78 s 4 21 s 3s
4

(ii) maturity 30 nov. 2010 31 may. 2011 30 nov. 2011 Portfolio 30 nov. 2011

(iii) face amount -1.779 -1.790 98.166 100

date cash flows

(iv) 30 nov. 2010 -1.79 -0.044 2.209 0.375 0.375

(v) 31 may. 2011 -1.834 2.209 0.375 0.375

(vi) 30 nov. 2011 100.375 100.375 100.375

(vii) price 100.550 104.513 105.856 100.190

(viii) cost -1.789 -1.871 103.951 100.255 100.190

(ix) net proceeds 0.065

Felix Matthys Fixed Income ITAM 23 / 90

Arbitrage Pricing and Replicating Portfolios

The previous example has shown that we can price a coupon bond using two approaches
1 Pricing of the coupon bond by deriving the set of discount factors Z (t, T )
2 Find a replicating portfolio, consisting of a set of spanning bonds, that matches
the payoff characteristics of the bond we want to price

Equivalence: Discount factors and replicating portfolios

No arbitrage implies that cost of synthetic = price of actual bond and that there
exists a unique discount function Z (t, T )

Remark:
• In real-world markets with transaction costs, taxes etc, these results only hold
approximately (prices must be within ranges)

Felix Matthys Fixed Income ITAM 24 / 90

Arbitrage Pricing and Replicating Portfolios cont.
How to show this: If we have n bonds with cash flow matrix of dimension n × n
(invertible), i.e. we have the same amount of bonds and maturities. Then the discount
factor Z(t) ∈ Rn solves

C × Z (t) = P (t) ⇐⇒ Z (t) = C−1 × P (t)

Using the replication strategy, we obtain that

C×θ =c (5)

where θ ∈ Rn denotes the vector of portfolio weights and c ∈ Rn denotes the cash flows
of the bond to be replicated.
′
1 Then the price of the bond we want replicate using discount factors is c(t) × Z(t).
2 The price of the same bond using the replication strategy can be expressed as
′
P(t) × θ
Thus, if the market is free of arbitrage, then we must have that
′ ′
c(t) × Z(t) = P(t) × θ
′ ′
c (t) × C−1 × P(t) = P(t) × C−1 × c(t) (6)

Since both expressions in Equation (6) are scalars, this proves the claim.
Felix Matthys Fixed Income ITAM 25 / 90
Yield to Maturity (Bond Yield)
Important question: How can we measure the expected return on a bond investment?
• Consider a zero coupon bond with time - to- maturity τ = T − t. Assuming the
bond is held until maturity τ = 0 the annualized return is2
"  1 #
N n×τ
yz := yz (t, T ) = n × −1 , τ ≥0 (7)
Pz (t, T )

• For a bond that pays a coupon rate c% per year, it is no longer that obvious how
to measure the return on investment.

Definition: Yield of a bond (YTM)

The yield to maturity (YTM) is the single discount rate, when applied to all the cash
flows of the bond, gives its current market/present value.

⇒ For general investments it is called the internal rate of return, IRR. The IRR of a
bond is its yield or YTM.

2
Compare this expression to Equation (3).
Felix Matthys Fixed Income ITAM 26 / 90
Yield to Maturity (Bond Yield) cont.
• Suppose that a bond pays a face value equal to N and n coupon payments per
year at Ti , for i = 1, . . . , m, each of size c/n, at regular intervals.
• Suppose there are T − t years left until maturity for a total of ⌊(T − t) × n⌋ = m
periods until maturity.

Definition: Yield-to-Maturity (YtM)

Then the yield-to-maturity yn of the bond solves:
m
! m
cX N X c/n
Pc (t, T ) = N Z (t, Ti ) + Z (t, Tm ) = + N ×
n i=1 [1 + yn /n]m i=1
[1 + yn /n]i
m
!
X c/n 1
=N +
yn n·(Ti −t) yn n·(Tm −t)



i=1 1 + n 1+ n
or with continuous compounding
m
!
X c −iy /n
= N e −(T −t)y + e
i=1
n

• We can see that the yield yn is the interest rate implied by the current market price
of the bond (IRR).
Felix Matthys Fixed Income ITAM 27 / 90
Comparing Bonds by YTM
Suppose you have the following two bonds available:

Bond 1 Bond 2

Coupon rate 0.06 0.025

Comp. Freq. Semi-annual

Face Value 100 $

Maturity 2 years

Current Price 101.3376 94.7527

and the corresponding zero rates are r (t, t + 0.5) = 0.0455, r (t, t + 1) = 0.0467,
r (t, t + 1.5) = 0.0492 and r (t, t + 2) = 0.0531. Which bond ’better’ in terms of return?
• Bond 1 has a higher coupon rate c but is also more expensive than bond 2.

Felix Matthys Fixed Income ITAM 28 / 90

Comparing Bonds by YTM
Suppose you have the following two bonds available:

Bond 1 Bond 2

Coupon rate 0.06 0.025

Comp. Freq. Semi-annual

Face Value 100 $

Maturity 2 years

Current Price 101.3376 94.7527

and the corresponding zero rates are r (t, t + 0.5) = 0.0455, r (t, t + 1) = 0.0467,
r (t, t + 1.5) = 0.0492 and r (t, t + 2) = 0.0531. Which bond ’better’ in terms of return?
• Bond 1 has a higher coupon rate c but is also more expensive than bond 2.
→ YTM for bond 1 is y1 = 5.286% and for bond 2 y2 = 5.30% which indicates that
bond 2 delivers a higher return!
Key assumption: Investor can reinvest all the coupons at the rate yi over the lifetime of
the bond!
Felix Matthys Fixed Income ITAM 28 / 90
 Don’t get Confused: Term Structure vs. YtM

Yield-to-Maturity YtM: Term Structure of Interest Rates & YtM

3.1
• YtM is a constant rate with maturity T
3
• YtM measures the ”average” return on a
bond 2.9

• Assumes that all cash flows can be

2.8
reinvested at the same (YtM) rate
2.7
• YtM is bond specific: Depends on the
coupon rate, payment frequency and 2.6
maturity YtM: yn
2.5
Term Structure of Interest Rates (TSoIR) or TSoIR: rn (t, T )
yield curve: 2.4
5 10 15 20 25 30

• Plots the interest rate/zero rate or yield as Remarks:

a function of maturity T • Term structure data from the Federal
Reserve Board from August 3rd, 2018

Felix Matthys Fixed Income ITAM 29 / 90

A useful summation formula

Proposition:
Let a, b ∈ N and q ∈ R, then we have the following result
b
X q a − q b+1
qt =
t=a
1−q

Felix Matthys Fixed Income ITAM 30 / 90

A useful summation formula

Proposition:
Let a, b ∈ N and q ∈ R, then we have the following result
b
X q a − q b+1
qt =
t=a
1−q

Proof:

Felix Matthys Fixed Income ITAM 30 / 90

Yield to Maturity (Bond Yield) cont.

Using the formula from the previous page we obtain

!
c 1 N
Pc (t, T ) = N × 1−
m +
m
yn 1 + ynn 1 + ynn

Remarks:
• When c = yn , the bond trades a par value, i.e. Pc (t, T ) = N.
• When c > yn , the bond trades at a premium to par, Pc (t, T ) > N.
• When c < yn , the bond trades at a discount to par, Pc (t, T ) < N.

Felix Matthys Fixed Income ITAM 31 / 90

Par Yield
Definition: Par Yield/Rate
The par yield/rate cp,n on a bond with maturity T − t and payment frequency n per
year is the coupon rate that sets the bond price equal to its par/face value N. More
formally, cn,p at frequency n solves
m
1 X cp,n /n
1= m
+ i
[1 + rn (t, Tn )/n] i=1
[1 + rn (t, Ti )/n]

which can be explicitly solved for the par yield

1
1− [1+rn (t,Tm )/n]m n(1 − Z (t, Tm ))
cp,n = Pm 1/n
= Pm
i=1 [1+rn (t,Ti )/n]i i=1 Z (t, Ti )

Remark:

• The par rate above can not be computed using the yield to maturity y , as the yield
to maturity is the one interest rate that gives us the current bond price Pc (t, T ).
• If the yield to maturity is equal to the par rate, then we must have that the bond
price trades at par, i.e. Pc (t, T ) = N.

Felix Matthys Fixed Income ITAM 32 / 90

Exercise (Yield To Maturity)
Consider a US Treasury note with the following characteristics
• Coupon rate of 6%.
• Maturity: 1.5 Years.
• Face value N = $100.
• Compounding frequency: Semi-annual.
• Zero rates: r2 (t, t + 0.5) = 0.0455, r2 (t, t + 1) = 0.0458, r2 (t, t + 1.5) = 0.0489

Questions:
• What is the market price of the bond at time t?
• Is the bond selling at par, at discount or at a premium? Is c > y or the reverse?
• What is the par rate c2,p for this bond?
• What is the continuously compounded par rate cp ?

Felix Matthys Fixed Income ITAM 33 / 90

Solution to Exercise

Felix Matthys Fixed Income ITAM 34 / 90

Discount yield and Bond Equivalent Yield
• T-bills are quoted on a discount yield d basis. That is, the quote reports a yield.
• If n is the number of days to maturity, the price of the T-bill is
h n i
P = 100 × 1 − ×d
360
• In other words
100 − P 360
d= ×
100 n
so d denotes the annualized discount rate on the face value of the Treasury bill.
• Instead, it should be
100 − P 365
BEY = ×
P n
• BEY = Bond Equivalent Yield. Allows fixed-income securities whose payments are
not annual (semi-annual, quarterly, monthly etc.) to be compared with securities
with annual yields.
• Of course, we obtain
365 × d
BEY =
360 − d × n

Felix Matthys Fixed Income ITAM 35 / 90

Extracting the Zero-Coupon Discount Curve
There are several methods to extract the zero-coupon discount curve Z (0, T ) from
bond data.
• Why do we want to do that?
• The discount function Z (0, T ) determines the time value of money. We
need it as a basis to discount future (riskless) cash flows.
• We cannot observe it: it is implicitly embedded in traded Treasury coupon
bonds.
• You need it to compute forward prices, for instance, as well as Swaps (see
later).
• It will be the basis of all future term structure models: it is typically the first
step to then calibrate term structure models. The latter are what traders use
to
• Price new securities by no arbitrage (we will see many).
• Spot out arbitrage opportunities.
The most ”famous” is the bootstrapping methodology.

Felix Matthys Fixed Income ITAM 36 / 90

Bootstrap
• Suppose we have n coupon bonds. Each bond i has a coupon equal to ci paying
semi-annually.
• Since we have n bonds, we have also n maturities, so that, generically, we can
denote the price of bond i with maturity Ti as Pi (t, Ti ).
• Recall the pricing equation for coupon bonds with maturity Ti is equal to
i
!
ci X
Pi (t, Ti ) = N × Z (t, Tj ) + Z (t, Ti ) (8)
2 j=1

• Suppose today t = 0 and that we have available the price of bonds for every
maturity Tj = 0.5, 1, 1.5, ....Tn . Inverting (8), we obtain
P1 (0, 0.5)
Z (0, 0.5) =
N (1 + c1 /2)
P2 (0, 1) − Nc2 /2 × Z (0, 0.5)
Z (0, 1) =
N (1 + c2 /2)
P3 (0, 1.5) − Nc3 /2 × (Z (0, 0.5) + Z (0, 1))
Z (0, 1.5) =
N (1 + c3 /2)
• In general, for every i: P
i−1

Pi (0, Ti ) − Nci /2 × j=1 Z (0, Tj )
Z (0, Ti ) =
N (1 + ci /2)
Felix Matthys Fixed Income ITAM 37 / 90
Bootstrapping the zero bond curve
Exercise (Bootstrapping)
Suppose we have the following data:

Maturity Period i Coupon YTM Price

0.5 1 0.000 0.080 96.15

1 2 0.000 0.083 92.19

1.5 3 0.085 0.089 99.45

2 4 0.090 0.092 99.64

2.5 5 0.110 0.094 103.49

3 6 0.095 0.097 99.49

3.5 7 0.100 0.100 100.00

Felix Matthys Fixed Income ITAM 38 / 90

Bootstrapping the zero coupon yield curve

Exercise (Questions:)
• Given a face value N = 100$, what are the bootstrapped discount factors Z (t, T )
for each maturity Ti , i = 1 . . . , 7?
• Determine the zero coupon yield curve, i.e. compute r2 (0, i/2), for every
i = 1 . . . , 7.

Felix Matthys Fixed Income ITAM 39 / 90

Felix Matthys Fixed Income ITAM 40 / 90
Felix Matthys Fixed Income ITAM 41 / 90
Bootstrap with Matrix Algebra
• The iterative procedure described in the text is simple, but cumbersome. An easier
way to obtain the same result is to use the matrix notation.
• Every coupon bond i is characterized by a series of cash flows, that we can put in
a row vector:
Ci = (ci (T1 ) , ci (T2 ) , ..., ci (Tm ))
where we set the cash flow paid at time Tj of bond i to ci (Tj ) = N × ci /2 if
Tj < Ti and ci (Tj ) = N × (1 + ci /2) and ci (Tj ) = 0, if Tj > Ti
• We can denote by Z (t) the zero coupon discount function, which is a column
vector  
 Z (t, T1 ) 
 
 
 Z (t, T ) 
 2 
Z (t) =  

 .
..


 
 
 
Z (t, Tm )

• The price of a coupon bond can be written more simply as:

Pi (t, T ) = Ci ×Z (t)

Felix Matthys Fixed Income ITAM 42 / 90

The Price of a coupon bond expressed in Matrix Notation

• We can denote the column vector of bond prices as

 
 P (t, T1 ) 
 
 
 P (t, T ) 
 2 
P (t) =  

 .
..


 
 
 
P (t, Tm )

• We then obtain a system of m equations with m unknowns (the values of

Z (t, T1 ) , ..., Z (t, Tm ))
P (t) = C × Z (t)

Felix Matthys Fixed Income ITAM 43 / 90

The Cash Flow Matrix
• where C is the cash-flow matrix:
 
 c1 (T1 ) c1 (T2 ) ... c1 (Tm ) 
 
 

 c2 (T1 ) c2 (T2 ) ... c2 (Tm ) 

C=  
 .. .. .. 

 . . .


 
 
cm (T1 ) cm (T2 ) ... cm (Tm )

• Essentially, each row i of C corresponds to the cash flows of bond i during all the
maturities T1 ,...,Tm . In contrast, each column j describes all the cash flows that
occur on that particular maturity Tj from the m bonds.
• So, the discount function can be obtained simply by

Z (t) = C−1 × P (t)

Note: We need the cash flow matrix C to be invertible for this approach to work. In
other words, we need exactly the same number of bonds n and maturities Ti ,
i = 1, . . . , m.
Felix Matthys Fixed Income ITAM 44 / 90
Regression Approach

• The main problem with extracting zero coupon bonds using the matrix algebra is
that we rarely have nicely spaced data.
• Sometimes we have too many maturities and sometimes we do not have any
maturity.
• The regression methodology deal with the case where there are too many bonds
compared to the number of maturities.
• This is typically the case when we consider maturities up to 10 years.
• For example, there are 81 quoted coupon bonds with maturity less than 5 years.
• But there are only 60 months in 5 years, implying that for this horizon we have too
many bonds.

Felix Matthys Fixed Income ITAM 45 / 90

Regression Approach cont.

• In other words, when we compute the cash-flow matrix:

 
 c1 (T1 ) c1 (T2 ) ... c1 (Tm ) 
 
 
 c (T ) c2 (T2 ) ... c2 (Tm ) 
 2 1 
C =
 .

 . .. .. 
 . . .


 
 
cN (T1 ) cm (T2 ) ... cm (Tm )

• we end up with N rows (N = 81 = number of bonds) and m < N columns

(m = 60 = number of maturities).
• Since the solution to boostrap involves inverting the matrix C, we have a problem
(the matrix C has to have equal number of rows and columns to be inverted).
• We can slightly change the bootstrap methodology to deal with this problem.

Felix Matthys Fixed Income ITAM 46 / 90

Regression Approach cont.
• For every bond i = 1, ..., m let
Pi (t) = Ci ×Z (t) + εi (9)
• where εi is a random error term that captures any factor that generates the
”misspricing” (staleness, liquidity etc).
• If we look at equation (9), we essentially see a regression equation of the type
m
X
yi = α + βj xij + εj
j=1

• where the data are yi = Pi and xij = Cij , and the regressors are βj = Z (t, Tj );
• From basics OLS, we then find that
b (t) = C′ × C −1 C′ × P (t)


Z

where Zb is the OLS estimator usually denoted by β.b

• For this to work, however, we must have more bonds than (cash-flow)
maturities.
• Not necessarily true if we look at the long term: A thirty year bond involves
already 60 maturities!
• Other bond markets have much fewer maturities.
• The curve fitting methodology addresses this issue.
Felix Matthys Fixed Income ITAM 47 / 90
Curve Fitting: General comments
• The above methodologies require that we have all the maturities available.
• In practice however, this is never the case as we only have maturities for some
selected years.
• For instance 1M, 3M, 6M, 1Y, 2Y, 3Y, 5Y, 7Y, 10Y and 20Y (data from the
federal reserve board).
• Note data is not equidistant!
• To avoid this problem, the profession moved to curve fitting

Main idea:
• Assume a parametric form of the discount factor Z (t, T ), that is take an explicit
functional form for Z (t, T ) and then try to match it to the data (current time t
bond prices). The discount factor is given by

Z (t, T ) = e −r (t,T )(T −t)

where r (t, T ) is the continuously compounded interest rate with maturity T .

Fundamental Question: What is a good functional form for the yield r (t, T )?

Felix Matthys Fixed Income ITAM 48 / 90

Curve Fitting: General comments cont.

Advantage:
• This approach gives us a continuous function in time to maturity for the yield
r (t, T ). In other words, for every time to maturity τ ≥ 0 we can compute the
corresponding yield r (t, T )
Problem with this approach:
• We need to estimate/calibrate parameters (estimation error). What is the right
optimization technique?
• The functional form we use for the yield r (t, T ) might be inappropriate for
modeling the term structure. For some types of curves, the assumed parametric
form of the yield r (t, T ) might not be able to reproduce the market data
(especially when yield curve is highly non-linear).

Felix Matthys Fixed Income ITAM 49 / 90

Curve Fitting using Nelson & Siegel
• For each bond i = 1, . . . , m with coupon rate ci and cash flow payment dates Tji
for j = 1, . . . , mi the model-implied price of the coupon bond is given by
mi
!
M ci X
Pc,i (t, Ti ) = N × Z (t, Ti,j ) + Z (0, Ti )
ni j=1

• Early suggestion due to Nelson and Siegel: Assume Z (0, T ), is such that:
Z (t, Tj ) = e −r (t,Tj )×(Tj −t)
(Tj −t)
1 − e− λ (Tj −t)
r (t, Tj ) = θ0 + (θ1 + θ2 ) (Tj −t)
− θ2 e − λ

• Question: How do we find appropriate values for the parameters λ and θ0 , θ1 , θ2 ?

• We estimate the parameters by non-linear least squares. That is, by minimizing
n 
X 2
min V (Θ) = min ∥ PcM (t, T ) − PcD (t, T ) ∥2 = min M
Pc,i (t, T ) − Pci,D (t, T )
Θ∈R4 Θ∈R4 Θ∈R4
i=1

where Θ = {λ, θ0 , θ1 , θ2 }.
• Put differently, we try to make the difference between the model implied prices
M D
Pc,i (t, Ti ) and their market (data) prices Pc,i as small as possible.
Felix Matthys Fixed Income ITAM 50 / 90
Curve Fitting

• The Nelson Siegel Model works nice, but it lacks the flexibility to match term
structures that are highly non-linear.
• Lars Svensson proposed a simple extension to the model, which is the one most
widely adopted.
• In particular, we assume:

Z (t, Tj ) = e −r (t,Tj )×(Tj −t)

(Tj −t) (Tj −t)
 
− (Tj −t) − (Tj −t)
1−e λ1
−
1 − e
λ2
−
r (t, Tj ) = θ0 + (θ1 + θ2 ) (Tj −t)
− θ2 e λ1
+ θ3 (Tj −t)
−e λ2 
λ1 λ2

• Therefore, we minimize the following objective function

n 
X 2
min V (Θ) = min ∥ PcM (t, T )−PcD (t, T ) ∥2 = min Pci,M (t, T ) − Pci,D (t, T )
Θ∈R6 Θ∈R6 Θ∈R6
i=1

where Θ = {λ1 , λ2 , θ0 , θ1 , θ2 , θ3 } the set of parameters.

Felix Matthys Fixed Income ITAM 51 / 90

Quoting Conventions: General

• Market conventions often cause confusion in the study of fixed income securities.
• Conventions vary according to the location and the type of instruments one is
concerned with.
• Two instruments that are similar may be quoted in very different ways depending
on where the are traded.
• In financial markets, we always have two prices. The ask and the bid price. The
ask price is the price at which the market is willing to sell. The bid price is the
price at which the market is willing to buy.
• The difference is called the bid-ask or bid-offer spread.
• A typical quote for deposits in London money and foreign exchange markets is

Ask Bid

5 14 5 81

Felix Matthys Fixed Income ITAM 52 / 90

Quoting Conventions: General cont.

• Another characteristics of quotes is the decimalization.

• Eurodollar interest rates in London are quoted to the nearest 1/16 or sometimes
1/32. But many financial centers quote interest rates to two decimal points.
• Decimalization is not a completely straightforward issue from the point of view of
brokers/dealers.
• Note that with the decimalization, the bid-ask spreads may narrow all the way
down to zero. This may lower profits, everything else being the same.
To sum up: The definition of a year or of a month may change from one market to
another and the quotes that one observes will depend on this convention.

Felix Matthys Fixed Income ITAM 53 / 90

Day Count Conventions

• The major day count conventions are as follows

• Actual/Actual: Simply count the number of calendar days;
• 30/360: Assume there are 30 days in a month and 360 in a year;
• Actual/360: Each month has the right number of days, but there are only
360 days in a year.
• Which convention it is used depend on the security considered.
• Treasuries use Actual/Actual.
• Example with 30/360 basis. Every month has 30 days regardless of the actual
number of days in that particular month, and a year has always 360 days. E.g., an
instrument purchased on May 1 and sold on July 13 would earn interest on

30 + 30 + 12 = 72

days, while the actual calendar would give 73 days. More interestingly, the same
instrument purchased on February 28, 2003, and sold the next day, on March 1,
2003, would earn interest for 3 days. Yet, a money market instrument such as the
interbank deposit would have earned interest only 1 day.

Felix Matthys Fixed Income ITAM 54 / 90

Day Count Conventions cont.

Which market uses which day count convention?

• The Act/360 basis. This convention is used by most money markets.
• The Act/365 basis. This convention is used by Eurosterling money markets.
• The Act/Act basis is used by many bond markets
Additional complications:
• Holiday conventions: Besides the day count conventions, there are also holiday
conventions. Each financial contract stipulates the particular holiday schedule to be
used, and then specify the date of the cash settlement if it falls on a holiday. This
could be the next business day or the previous business day, or other arrangements.

Felix Matthys Fixed Income ITAM 55 / 90

 Day Count Yield
United States
Depo/CD Act/360 Yield
TBill/CP/BA Act/360 Discount
Treasuries Act/Act (s.a.) B-E yield
Repo Act/360 Yield
Euromarket
Depo/CD/ECP Act/360 (Act/365 for £) Yield
Eurobond 30E/360 Yield
United Kingdom
Depo/CD/Sterling CP Act/365 Yield
BA/Tbill Act/365 Discount
Gilt Act/365 (s.a.) B-E yield
Repo Act/365 Yield
Germany
Depo/CD/Sterling CP Act/360 Yield
Bund 30E/360 B-E yield
Repo Act/360 Yield
Japan
Depo/CD Act/365 Yield
Repo domestic Act/365 Yield
Repo international Act/360 Yield

Felix Matthys Fixed Income ITAM 56 / 90

A Eurodollar deposit:

Amount $100, 000

Trade date Tuesday, June 5, 2002

Settlement date Thursday, June 7, 2002

Maturity Friday, July 5, 2002

Days 30

Offer rate 4.789%

Interest earned 100, 000 × 0.04789 × 30/360

• Depositor earns interest on the trade date, but not for the day the contract
matures.
• We are looking at the deal from the bank’s side, since we quote the offer rate.
• The interest rate earned is expressed using the formula r · ∆(Days) × 100, 000.

Felix Matthys Fixed Income ITAM 57 / 90

Accrued Interest
• A bond is rarely sold or bought at the bonds’ coupon dates. Therefore, if a bond is
bought between coupon dates, the seller is entitled to the share of coupon
payments which occurred between the last coupon payment date and the purchase
date. On the other hand, the buyer is entitled to the coupon payments which
accrued between the purchase price date and the next coupon payment date.
• It is market convention to not include any accrued interest when quoting Treasury
notes and bonds.
• Useful market practice of separating the full price of a bond (price paid by buyer to
seller) into two parts:
• Invoice price = Quoted price + accrued interest
• Accrued Interest = Interest due during the whole period
# days since last coupon payment
×
# days between two consecutive coupon payments

• The full (invoice,cash) and quoted price are also known as the dirty and clean
prices, respectively.
• The clean price is typically the quoted price on financial news sites.3

3
This is the case for the United states, whereas, for instance in Europe, the quoted price is usually the dirty price.
Felix Matthys Fixed Income ITAM 58 / 90
Example: Accrued Interest

• Share of accrued interest that belongs to the seller is N × c/n × 106/181

Felix Matthys Fixed Income ITAM 59 / 90

Felix Matthys Fixed Income ITAM 60 / 90
Felix Matthys Fixed Income ITAM 61 / 90
Exercise (Accrued Interest on Fixed Rate Bond)
Suppose on 11.11.2005, you buy e1’000 of the bond issued below and the face value is
N = 100 per bond.a

a
Note: The day count convention is actual/actual.
Felix Matthys Fixed Income ITAM 62 / 90
Felix Matthys Fixed Income ITAM 63 / 90
Felix Matthys Fixed Income ITAM 64 / 90
Floating Rate Bonds

• A floating rate bonds is a bond with a coupon that is indexed to a benchmark

interest rate, i.e. the coupons of the bond depend on a reference interest rate.
• Some examples include:
1 US Treasury rates,
2 LIBOR
3 municipal and mortgage interest rate indexes.
Examples of floating rate notes
1 Corporate (especially financial institutions)
2 Adjustable-rate mortgages (ARMs)
• FRN is an abbreviation for floating rate note (usually refers to an instrument
whose coupon is based on a short term rate (3-month T-bill, 6-month LIBOR))
• VRN refers to variable rate note which are typically based on longer-term rates
such as for instance the 1-year T-bill or the 5-year T-bond

Felix Matthys Fixed Income ITAM 65 / 90

Floating Rate Bonds cont.
• The basic semi-annual coupon floating rate note has the coupon indexed to the
6-month interest rate.

Definition: Floating Rate Bond

The coupon payments of a floating rate bond, who is paying n coupons a year with
payments dates t + i/n, i = 1, . . . , m and maturity T are determined as follows
 
rn (t + (i − 1)/n, t + i/n) + s
c(t + i/n) = N × , i = 1, . . . , m
n

where N is the face value, rn (t, t + 1/n) is the n month Treasury rate at time t and s is
the spread.

• If n = 1 annual coupon payments and r1 (t, t + 1) denotes the annual treasury rate
at time t, if n = 2 semi-annual coupon payments and r1 (t, t + 1/2) denotes the
semi-annual treasury rate at time t, etc.
• Convention: Each coupon date is called the reset date, as it is the date when the
new coupon is fixed according to Equation (66).
• Thus, only the next coupon is known at the current date t. In other words,
r (t, t + 1/n) is known at t but not r (t + 1/n, t + 2/n) and r (t + 2/n, t + 3/n) etc.
are all unknown at time t!
Felix Matthys Fixed Income ITAM 66 / 90
Floating Rate Bonds cont.

• Each coupon is based on the previous 0.5-year interest rate.

Graphical illustration:

Felix Matthys Fixed Income ITAM 67 / 90

Pricing of Floating Rate Bonds: Example

Consider a one year floating rate bond with semi-annual coupon payments and the
spread s is equal to zero.
• The coupon payment at time t = 0.5 depends on today’s interest rate r2 (0, 0.5)
which is known.
• Suppose r2 (0, 0.5) = 2% then c(0.5) = 100 × 0.02/2 = 1.
• The coupon at time t + 1 will depend on the prevailing interest rate at t + 0.5
until t + 1, i.e. r2 (0.5, 1) which we do not know today at t = 0.
• Thus the cash flow at t + 1 is 100 + c(1) = 100 × r2 (0.5, 1)/2
• Question: How do we price this bond when we do not know the size of the
coupon payments at t + 1, i.e. the coupon rate is random?

Felix Matthys Fixed Income ITAM 68 / 90

Pricing of Floating Rate Bonds: Example cont.
• Note: At time t = 0.5 the investor knows what the final coupon rate will be.
Suppose the interest rate at 0.5 is r2 (0.5, 1) = 0.03.
• Therefore, the coupon at maturity t = 1 is c(1) = 100 × r2 (0.5, 1)/2 = 1.5
• Therefore, the value of the floating rate bond at time t = 0.5 is
100 + 3/2
FRB(0.5) = N × (1 + c(1)/2) × Z (0.5, 1) = = 100
1 + 0.03/2
where Z (0.5, 1) is the semi-annually compounded discount factor between t = 0.5
and t = 1.
• Observation: The floating rate bond trades at par.
• Suppose that r2 (0.5, 1) = 0.06 at time = 0.5. Then we get
100 + 6/2
FRB(0.5) = N × (1 + c(1)/2) × Z (0.5, 1) = = 100
1 + 0.06/2
which is also equal to par again! Indeed, independently of the interest rate level
r2 (0.5, 1) we obtain that the price of the floating rate bond is equal to its face
value 100
1 + r2 (0.5, 1)/2
FRB(0.5) = 100 × = 100
1 + r2 (0.5, 1)/2
Felix Matthys Fixed Income ITAM 69 / 90
Pricing of Floating Rate Bonds: Example cont.

What do we learn from this observation?

• Even though the investor does not know the coupon payment at maturity t = 1,
because it depends on the prevailing interest rate r2 (0.5, 1), the investor does know
that at time t = 0.5, the ex-coupon value of the floating rate bond is par!
• But then, the investor can also compute the value of the FRB at time t = 0 as
r2 (0, 0.5) is known.

1 + r2 (0, 1/2)/2
FRB(0) = 100 × = 100
1 + r2 (0, 1/2)/2

• Therefore,

The value of a FRB at time t = 0 is equal to the bonds par value!

Felix Matthys Fixed Income ITAM 70 / 90

Pricing of Floating Rate Bonds: Example cont.
Why is this happening?
1 ”Cash flow effect”
▶ If the interest rate r2 (t, t + 1/2) rises the future cash flow rises as well
▶ Conversely, if the interest rate r2 (t, t + 1/2) declines, then the future cash
flow fall as well.
2 ”Discount effect”
▶ If the interest rate r2 (t, t + 1/2) rises the discount factor falls
▶ Conversely, if the interest rate r2 (t, t + 1/2) declines, then the discount
rate increases.
• Those two effects work in opposite directions. If interest rates increase, so do the
cash flows but they will be discounted at a higher rate Z .

• Lagging the coupon payments by precisely six months leads the cash flow and the
discount effect to exactly cancel each other out and therefore leaving the bond
value at par at any reset date.

Felix Matthys Fixed Income ITAM 71 / 90

Complications

We made two simplifying assumptions:

1 The spread s was set to zero.
2 The time t evaluation is also a reset date.
Some remarks:
• A spread is usually charged to reflect lower credit quality of the issuer.
• Furthermore, depending on the benchmark rate that is being used, the
appropriate discount factors should be employed to discount future cash
flows.
• For instance, if the reference rate is LIBOR, then the LIBOR curve should be
used to compute the discount factors.

Felix Matthys Fixed Income ITAM 72 / 90

Non zero spread

If the spread is nonzero, we can decompose the coupon payments into a two parts.
1 The floating rate which depends on the reference interest rate
2 and the fixed spread s .
In other words,

Floating Coupon with spread s = Floating Coupon with zero spread + Fixed coupon s

Thus the price of a floating rate bond with spread s denoted by FRBs (t) with n coupon
payments per year and T years until maturity, decomposes as follows,
m
s X
FRBs (t) = FRB(t) + N × Z (t, t + i/n), m =T ·n
n i=1
m
s X
= 100 + N × Z (t, t + i/n)
n i=1

where FRB(t) refers to a floating rate bond without spread.

Felix Matthys Fixed Income ITAM 73 / 90

Valuation date is not on a reset date
Suppose we want to value the floating rate bond not at time t but at time t + 0.25 (a
quarter of a year)
• The backward induction until time t = 0.5 still holds.
• Thus at time t + 0.5 the FRB trades at par and the coupon bond will be worth
100 × (1 + 0.02/2) = 101.
• The only difference now is that we do not discount the 101 back to t at a rate
r2 (0, 1/2) = 2% but instead back to only t = 0.25 at the current 3-month rate.
• If the quarterly compounded interest rate is r4 (0.25, 0.5) = 0.02, then the price of
the FRB at time t = 0.25 is
1 + r2 (0, 0.5)/2 101
FRB(0.25) = N = = 100.4975 (10)
1 + r4 (0.25, 0.5)/4 1 + 0.02/4

or 100.7481 if the quarterly compounded rate is r4 (0.25, 0.5) = 0.01.

Thus for 0 ≤ t ≤ 0.5 the value of the floating rate note is

FRB(t) = Z (t, 0.5) × 100 × (1 + r2 (0, 1/2)/2)

Felix Matthys Fixed Income ITAM 74 / 90

Floating Rate Bond: A General Evaluation Formula

Suppose that T1 , T2 , . . . , Tn are the floating rate reset dates per year with T − t years
until maturity. Let the current date t be between (Ti , Ti+1 ). Then the price of a
semi-annual floating rate bond with spread s is given by
 s
FRB(t, T ) = N × Z (t, Ti+1 ) (1 + r2 (t, t + 1/n)/n) + ,
n
where Z (t, Ti+1 ) is the discount factor from t + u to Ti+1 and m = n(T − t). At the
reset dates, which corresponds to t = Ti in Equation (75), we obtain that
1
Z (Ti , Ti+1 ) = r2 (Ti ,Ti+1 )
1+ n

and thus
m
s X
FRB(t, T ) = 100 + ×N × Z (t, t + 1/n · i)
n i=1

where n = 2 if the floating rate bond pays semi-annually.

Felix Matthys Fixed Income ITAM 75 / 90

Summary
Key concepts:
✓ Discount Factors Z (t, T ): Is the value today of receiving a dollar some
predetermined time in the future. Discount factors are decreasing in maturity and
fluctuate over time.
✓ Interest Rate: Rate of return on an investment over a given time period T − t.
Note: Interest rates are always quoted on a annualized basis.
✓ Compounding frequency: Indicates how many times interest is paid out.
Continuous compounding is equivalent to interest rate payments that occur
infinitely often.
✓ Term Structure of Interest Rates/Yield Curve: Plots the interest rate as a
function of maturity. It can be upward (normal), flat or downward sloping
✓ Replicating portfolios: Those portfolios aim at replicating a payoff of some fixed
income asset/portfolio. They can be used to check whether the market is arbitrage
free.
✓ Yield-to-maturity (YtM): Is a measure of return on a fixed income asset, and
allows us to compare different bonds

Felix Matthys Fixed Income ITAM 76 / 90

Summary cont.

✓ Extracting discount factors from the data:

: Bootstrap method
: Regression approach
: Curve fitting
✓ Day count conventions: They are used to calculate the amount of interest on fixed
income securities. They also play an important role in the pricing of fixed income
assets and derivatives
✓ Accrued interest: Is the amount of money that belongs to the seller of the bond
if it is not sold at a coupon date.
✓ Floating rate bonds/notes: Their coupon is tied to a variable reference rate (for
instance LIBOR). They can be issued with a spread, where this spread is
determined by the credit quality of the issuer.

Felix Matthys Fixed Income ITAM 77 / 90

 Appendix

Felix Matthys Fixed Income ITAM 78 / 90

Yield-to-Maturity (or internal rate of return)

• Given price P (t, T ) and cash flows c/2 at Ti ’s for i = 1, .., n, and 1 + c/2 at Tn ,
the (semi-annually compounded) yield-to-maturity YTM is defined as that rate y
such that
n
X c/2 100
P (t, Tn ) = + (11)
y 2×(Ti −t) y 2×(Tn −t)



i=1 1 + 2 1+ 2
• Recall that given the spot curve r2 (t, Ti ), we also had
n
X c/2 100
P (t, Tn ) = +
i=1 (1 + r2 (t, Ti ) /2)2×(Ti −t) (1 + r2 (t, Tn ) /2)2×(Tn −t)

Felix Matthys Fixed Income ITAM 79 / 90

• What’s the difference?
• The yield to maturity y is a sort of average discount rate that characterizes
one particular bond, and it is used to discount the cash flows of that
particular bond.
• Notice that two different bonds with same maturity, will have different yield
to maturities if they have different coupons.

Felix Matthys Fixed Income ITAM 80 / 90

• We will almost never use the YTM as a measure neither of yield nor of anything
else.
• It is blatantly wrong as a measure of yield, as it assumes that all the coupons can
be reinvested at the constant y throughout the life of the bond.
• That is: not only it assumes a flat yield curve, but also one that does
not move over time.
• Example: consider the following data:

Bond Maturity (Years) Coupon Price Yield-to-Maturity

1 2 9% 98.57 9.82%

2 2 10% 100.34 9.80%

3 2 3% 88.00 9.91%

Felix Matthys Fixed Income ITAM 81 / 90

• What is the most attractive bond?
• Judging from the Yield-to-Maturity, bond 3 looks great.
• However, it is dominated by a combination of 1 and 2, as we can mimic
exactly its cash flows and find a (slightly) lower price.
• Let N1 and N2 , be the number of the first and the second coupon bonds in
the portfolio.
• Then

N1 × 9 + N2 × 10 = 3
N1 × 109 + N2 × 110 = 103

• Solving, we find that a portfolio long N1 = 7 units in the first bond and short
of N2 = −6 units in the second bond mimics exactly the cash flows of bond
3.
• The value of this portfolio is N1 × 98.57 + N2 × 100.34 = 87.95 < 88.
• The YTM of the portfolio is even bigger: YTM=9.94%.

Felix Matthys Fixed Income ITAM 82 / 90

• Why is this happening?
• The YTM measures the average return on the bond under the assumption
that all coupon are reinvested at the same rate y .
• With a non-flat term structure, this is simply not going to happen and using
YTM for relative pricing yields bad results.
• The low coupon in the third bond together with the fact that we cannot
re-invest at the high rate of 9.91% for the whole life of the bond yields the
implication that the third bond is “no better” than a portfolio of the other
two (which have lower YTMs).

Felix Matthys Fixed Income ITAM 83 / 90

Felix Matthys Fixed Income ITAM 84 / 90
Exercise (2. Bond Pricing and Yields)
Based on the semi-annually compounded yield curve (next slide), price the following
securities

(a) 5-year zero coupon bond

(b) 7-year coupon bond paying 15% semiannually
(c) 4-year coupon bond paying 7% quarterly
(d) 3 1/4-year coupon bond paying 9 % semiannually
(e) 4-year floating rate bond with zero spread and semiannual payments
(f) 5 1/2 year floating rate bond with 35 basis point spread with quarterly payments

Felix Matthys Fixed Income ITAM 85 / 90

 Maturity Yield Maturity Yield Maturity Yield

0.25 6.33% 2.75 6.86% 5.25 6.39%

0.5 6.49% 3 6.83% 5.5 6.31%

0.75 6.62% 3.25 6.80% 5.75 6.24%

1 6.71% 3.5 6.76% 6 6.15%

1.25 6.79% 3.75 6.72% 6.25 6.05%

1.5 6.84% 4 6.67% 6.5 5.94%

1.75 6.87% 4.25 6.62% 6.75 5.81%

2 6.88% 4.5 6.57% 7 5.67%

2.25 6.89% 4.75 6.51% 7.25 5.50%

2.5 6.88% 5 6.45% 7.5 5.31%

Table: Yield Curve on March 15, 2000 calculated from CRSP data (Daily Treasuries).

Felix Matthys Fixed Income ITAM 86 / 90

Felix Matthys Fixed Income ITAM 87 / 90