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LECTURE 2 NOTES

# LECTURE 2 NOTES - LECTURE 2 OUTLINE OVERVIEW OF THE LECTURE...

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LECTURE 2 OUTLINE OVERVIEW OF THE LECTURE FIXED INCOME SECURITY (F.I.S.) PRICES AND YIELDS --The Standard Relationship between Bond Prices and Yields --Complexities in Fixed Income Security Price-Yield Relationships (Different Compounding Periods, Zero-Coupon Bonds, and T-bills) MEASURING AND MANAGING INTEREST RATE RISK --The Problem of Interest Rate Risk --Duration and Convexity FIXED INCOME SECURITY PRICES AND YIELDS DEFINITION --F.I.S. are those securities where the issuer is to make payments to the investor at specified future dates. --These payments are fixed in nominal terms at the time the securities are issued. --This is true of most bonds and mortgages. --Other F.I.S. stipulate future payments that are tied in some specified way to future economic conditions, e.g. floating rate bonds. THE STANDARD RELATIONSHIP BETWEEN BOND PRICES AND YIELDS P= C y F y t t n n ( ) ( ) 1 1 1 + + + = P = the current market price of the bond n = the number of periods remaining until the bond matures C = the bond’s promised/contractual coupon payment per period F = the bond’s face value, or principal amount y = the bond’s yield to maturity Yield to Maturity: The return the bond holder will earn on the bond if he/she buys it at its current market price, receives all coupon and principal payments as promised, and holds the bond until maturity. Note: When required market yields go up, bond prices go down. 1

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Question: What is the current selling price of a Eurodollar bond with a \$100 face value, 9.9178% yield to maturity, 10% coupon rate, and 10 years remaining to maturity? (Coupon payments are made once a year) Answer: P=\$ 100.507 Premium Bond: A bond in which the PV of the bond is greater than its face value. Discount Bond: A bond in which the PV of the bond is less than its face value. Par Bond: A bond in which the PV of the bond is equal to its face value. COMPLEXITIES IN FIXED INCOME SECURITY PRICE-YIELD RELATIONSHIPS Different Compounding Periods --When the coupon payments are made semiannually: P= C y F y t t n n / ( / ) ( / ) 2 1 2 1 2 1 + + + = n = the number of semiannual periods remaining until the bond matures Question: Consider a domestic US bond with a 10% coupon rate and ten years remaining to maturity, which sells for \$102 (per \$100 face value). What’s the yield to maturity (annualized)?
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LECTURE 2 NOTES - LECTURE 2 OUTLINE OVERVIEW OF THE LECTURE...

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