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Topic 2

# Topic 2 - BMGT 343 Investments Prof Anna A Obizhaeva Office...

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1 Fixed Income Anna A.Obizhaeva BMGT 343: Investments Prof. Anna A. Obizhaeva Office: VMH 4428 Phone: (301) 405-7934 Email: [email protected] Section 0101 T Th 9:30-10:45 am in VMH 1336 Section 0201 T Th 11:00-12:15 pm in VMH 1336 Section 0301 T Th 12:30-1:45 pm in VMH 1336 Office Hours : Thu 3:00-4:00 pm or by appointment Fixed Income Anna A.Obizhaeva Fixed Income Topic 2: Bond Pricing

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2 Fixed Income Anna A.Obizhaeva Valuation of Bonds Consider a bond with annual coupon rate c % (i.e. annual coupon payment of c ) and T years to maturity . The PV of the bond’s cash flow and its price is where is the t-year spot rate. So far, we took the spot rates as given . However, where can we get these spot rates? T T r c r c r c P %) 1 ( 100 ... %) 1 ( % 1 2 2 1 + + + + + + + = t r t r Fixed Income Anna A.Obizhaeva U.S. Treasury Yield Curve yield
3 Fixed Income Anna A.Obizhaeva Inconsistency of U.S. Treasury Yield Curve Treasury Yield Curve is constructed from coupon-bearing securities. It is internally inconsistent , since using of YTMs for bonds with different maturities or different coupons can be misleading. In other words, the returns on the coupon bonds are usually not equal to their YTMs. Fixed Income Anna A.Obizhaeva Inconsistency (cont’d) Example: there are two coupon bonds: Cash flows at different dates from the same bond are discounted at the same rate . Cash flows at the same date from different bonds are discounted at different rates .

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4 Fixed Income Anna A.Obizhaeva Zero Coupon Bonds & Treasury STRIPS To avoid inconsistency, we can use Treasury STRIPS or zero- coupon bonds to construct “ zero yield curve “, which is used as the basis for most fixed income valuations and other analyses. The coupons might be “ striped out ” from the bonds and treated as stand-alone zero-coupon securities. For instance, a 5-year coupon bond with annual 3%-coupons can be stripped into 5 securities: Cash Flow Year 3 3 3 1 3 3 2 4 103 5 1-year zero-coupon bond 2-year zero-coupon bond 3-year zero-coupon bond 4-year zero-coupon bond 5-year zero-coupon bond Fixed Income Anna A.Obizhaeva Zero-Coupon Yield Curve Zero coupon
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