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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 Spring '08
 CHO
 Finance, $10, $15, $115, $126.5

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