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pace Bond Math Intuition

pace Bond Math Intuition - Bond Math Intuition(all of the...

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Bond Math Intuition (all of the calculations for this note were done in the pace pv example spreadsheet v1 which is on the blackboard – I would suggest playing in that spreadsheet to a get a feel for this if you are unsure) a) Suppose you are a banker and you lend money at 10% for one year (r(0,1)). If you lend $100 for a year, you would expect to get back $100 principal and $10 in interest after 1 year. (or $100*(1+10%). The 1.10 is the future value (fv(0,1)) of a dollar a year from now. b) Now suppose a client comes to you and says they can only pay you $100 in a year’s time. How much would you lend them? Well, we know from above (since the interest rate is still 10%) that the Loan Amount *1.1 must equal $100. So the Loan Amount = $100/1.1. The 1/1.1 =.909 is the discount factor (df(0,1)). International Finance Purnell Page 1
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c) Now suppose your client wants to borrow $100 not for one year but two years. Suppose further you know the forward rate from the end of year 1 through year two is 15% (r(1,2)). There are now three possible ways to proceed.
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