EC3333 Notes07 - Lecture 07 The Term Structure of Interest...

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Unformatted text preview: Lecture 07 The Term Structure of Interest Rates y The yield curve is a graph that displays the relationship between yield and maturity y Maturities from the same time point y Different shapes observed y Information on expected future short term rates can be implied from the yield curve y Major theories proposed to explain the observed yield curve Overview of Term Structure Treasury Yield Curves Bond Pricing y If yields on different maturity bonds are not all equal, how should we value coupon bond that makes payments at many different time points? y Which of these rates should we use to discount bond cash flow? y All of them, the YTMs for zero-coupon bonds. Need to consider each bond cash flow as a stand-alone zero-coupon bond when valuing coupon bonds Bond Pricing y Valuing a bond is valuing a cash flow y The present value (i.e. the current price or investment cost) of a cash flow must be unique y Otherwise, arbitrage opportunity y Compare a coupon bond and a set of stand-alone zero-coupon bonds y Bond stripping or bond reconstitution y The cash flow remains the same by construction y The present value must be the same y How to calculate the present value of a set of stand-alone zero-coupon bonds ? Prices and Yields to Maturities on Zero- Coupon Bonds ($1,000 Face Value) (Increasing YTM) Yields and Prices to Maturities on Zero- Coupon Bonds ($1,000 Face Value) (Increasing YTM) y We wish to value a 10% coupon with a maturity of 3 years y Annual payment y First year coupon payment $100 discounted at rate of the first yield 5% y Second year coupon payment $100 discounted at rate of the second yield 6% y First years coupon payment $100 and principal s$1,000 discounted at rate of the third yield 7% Yields and Prices to Maturities on Zero- Coupon Bonds ($1,000 Face Value) (Increasing YTM) 17 . 082 , 1 ) 1 ( 100 000 , 1 ) 1 ( 100 ) 1 ( 100 : ) 3 ( % 7 % 88 . 6 17 . 082 , 1 %) 7 1 ( 100 000 , 1 %) 6 1 ( 100 %) 5 1 ( 100 : Value Present 1 2 1 1 2 1 = + + + + + + − − < = = + + + + + + y y y YTM coupon year the YTM What Can a Yield Curve Tell?...
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EC3333 Notes07 - Lecture 07 The Term Structure of Interest...

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