FNCE 30001 Week 8 Coupon Bonds

FNCE 30001 Investments 8.
0
FNCE 30001 Investments
Semester 2, 2011
14 & 16 September 2011
Week 8: Coupon Bonds
Professor Rob Brown
FNCE 30001 Investments 8.1
Overview of Lecture
1. Review: Zeros and Fixed-coupon Bonds
2. Yield-to-maturity (ytm)
3. Bond Pricing in Practice (A): Australian Conventions
4. Bond Pricing in Practice (B): US Conventions
5. The Yield Curve
6. The Par Yield Curve
7. Finding the Zero Rate Curve: Bootstrapping
8. The Holding Period Return
Readings
Bodie et al, Chapters 14 and 15.
Reserve Bank of Australia, Pricing Formulae for Commonwealth
Government Securities, available from the RBA website at:
www.rba.gov.au/mkt-operations/tech-notes/pricing_formulae.html.
1. Review:
Zeros and Fixed-coupon Bonds
Review: Zeros and Fixed-coupon Bonds
Notation from last lecture
Par: Par value or face value or principal.
P
0
: Current (time 0) price
z
0T
: Zero rate from time 0 to time T.
d
0T
: Discount factor from time 0 to time T.
HPR
0T
: Holding period rate of return from time 0 to time T.
Zero-coupon bonds (zeros)
A single future cash flow (par, or face value).
Pricing formula:
The price (P
0
) is related to:
The par value (Par): positively
The zero rate (z
0T
): negatively
The term to maturity (T): negatively
For a zero, P
0
is always less than Par.
This is not necessarily true of fixed-coupon bonds.
( )
= =
+
0 0
0
1
T
T
T
Par
P d Par
z
Fixed-coupon bonds
The fixed-coupon bond is the classic bond type.
A fixed-coupon bond makes two kinds of payments:
Par value (face value): The payment the bond holder receives
at the end of the bonds life
- ie when the bond matures.
Interest (coupon payment): Additional pre-specified payments
made before (and on) the maturity date at pre-specified
intervals (eg yearly, half-yearly, quarterly).
- Usually expressed as an annual simple interest rate (%).
Example: Commonwealth Govt bond 6.50% May 2013
Par value is taken to be $100.
Coupon interest is paid twice per annum on 15 May and 15 November each year.
Each half-yearly coupon is x 6.50% x $100 = $3.25
If you bought this bond on, say, 31 August 2011, you would get these cash flows:
On 15 November 2011: $3.25
On 15 May 2012: $3.25
On 15 November 2012: $3.25
On 15 May 2013: $3.25
Also on 15 May 2013: $100.00
Example: Commonwealth Govt bond 6.50% May 2013
(contd.)
Of course, in practice you cant buy as little as a $100 bond.
Suppose you bought bonds with a par value of $10 million.
If you bought this bond on 31 August 2011, you would get these
cash flows:
On 15 November 2011: $325,000
On 15 May 2012: $325,000
On 15 November 2012: $325,000
On 15 May 2013: $325,000
Also on 15 May 2013: $10,000,000
A fixed-coupon bond is like a portfolio of constituent zeros.
If we know the prices (and hence the zero rates) of the
constituent zeros, then pricing a coupon bond is simple:
This is called pricing off the zero curve.
Practical problem: few zeros exist
Solutions to this problem are covered later in the lecture.
( ) ( )
( )
( )
+
= + + + + +
+
+ + +
+
0
2 3 1
01
02 03 0
0, 1
...
1
1 1 1
1
T T
T
T
C C C C C Par
P
z
z z z
z
Notation new this lecture
c : Coupon rate (%) per period
C: Coupon amount ($) per period = c Par
ytm :Yield-to-maturity (or just yield for short).
rr : Reinvestment rate
2. Yield-to-Maturity (ytm)
Yield-to-Maturity (ytm)
The yield-to-maturity (or just yield for short) is the single
discount rate that equates the bond price to the present value
of all future cash flows of the bond.
That is, the yield is the bonds internal rate of return.
The yield is a handy way to summarise a bond trade in a way
that everyone can immediately relate to.
In practice many bond dealers think in terms of yields rather
than the constituent zero rates.
When a bond is traded in the market, it is rare for the dollar
price of a trade to be reported.
For example, The Australian Financial Review reports on the
bond market but it doesnt provide the bond price
it provides the yield.
The next slide shows the yields for bond trading on 8 June
2011, as reported in The Australian Financial Review on 9 June
2011.
Bond series Yield (% pa) Bond series Yield (% pa)
5.75% Jun 2011 4.685 4.75% Jun 2016 5.040
5.75% Apr 2012 4.825 6.00% Feb 2017 5.115
4.75% Nov 2012 4.845 5.50% Jan 2018 5.175
6.50% May 2013 4.855 5.25% Mar 2019 5.215
5.50% Dec 2013 4.870 4.50% Apr 2020 5.230
6.25% Jun 2014 4.895 5.75% May 2021 5.255
4.50% Oct 2014 4.925 5.75% Jul 2022 5.290
6.25% Apr 2015 4.950 5.50% Apr 2023 5.360
Consider a bond that pays annual coupons.
Consider its price on a coupon date.
By definition, ytm is:
For a fixed-coupon bond, C is constant.
Using the formula for the present value of an ordinary annuity,
this formula can be simplified to:
( ) ( )
0
1
1
1 1
T T
C Par
P
ytm
ytm ytm
(
= + (
+ +
(

( ) ( )
+
= + + +
+
+ +
0
2
...
1
1 1
T
C C C Par
P
ytm
ytm ytm
Example
Consider a 3-year bond with these features:
Par value: $10,000,000
Coupon rate: 8% pa
Coupon frequency: 1 per year
The current zero rates are: 6.250% pa (1 year); 6.725% pa (2 years)
and 6.875% (3 years).
What is the market price of the bond?
What is its yield-to-maturity?
Answer to Example
The market price of the bond is:
( ) ( )
= + +
= + +
=
0
2 3
$800, 000 $800, 000 $10, 800, 000
1.0625
1.06725 1.06875
$752, 941.18 $702, 356.59 $8, 846, 986.66
$10, 302, 284.43
P
Answer to Example (contd.)
To find the yield-to-maturity we need to know what
value of ytm will solve this equation:
There is no analytic solution use numerical methods.
In practice, use (eg) Excels IRR function.
We find that ytm is approximately 6.85127% pa.
( ) ( )
+ + =
+
+ +
2 3
$800, 000 $800, 000 $10, 800, 000
$10, 302, 284.43
1
1 1
ytm
ytm ytm
Answer to Example (contd.)
To show this is right, we calculate the price:
( ) ( )
( ) ( )
+
= + +
+
+ +
= + +
= + +
=
0
2 3
2 3
1
1 1
$800, 000 $800, 000 $10, 800, 000
1.0685127
1.0685127 1.0685127
$748, 704.25 $700, 697.57 $8, 852, 882.30
$10, 302, 284.12
( rounding error of 31 cents)
C C C Par
P
ytm
ytm ytm
We can think of the yield as a complex kind of average of the
interest rates of the constituent zeros:
BUT the yield is also a function of the coupon rate.
Date
Cash
Flow ($)
PV (zero) PV (ytm)
PV(ytm) less
PV(zero)
1 $800,000 $752,941.18 $748,704.25 $4236.93
2 $800,000 $702,356.59 $700,697.57 $1659.02
3 $10,800,000 $8,846,986.66 $8,852,882.30 +$5895.64
SUM $10,302,284.43 $10,302,284.12
$0.31
(rounding)
Bonds that pay different coupons, but are otherwise
equivalent, have different prices and hence must have
different yields.
Example
We will redo the example but with a coupon rate of
5% instead of 8%.
Recall: Par = $10,000,000; T = 3 years.
1-year zero rate = 6.250% pa
Calculating the price:
Solving for the yield gives ytm = 6.85932% pa
( ) ( )
= + +
= + +
=
0
2 3
$500, 000 $500, 000 $10, 500, 000
1.0625
1.06725 1.06875
$470, 588.24 $438, 972.87 $8, 601, 237.03
$9, 510, 798.14
P
Summarising, for these 3-year bonds:
8% coupon yield = 6.85127% pa
5% coupon yield = 6.85932% pa
Difference = 0.00805% pa (ie 0.8 of a basis point)
So this must be trivial, right? Who would worry about 0.8
of a basis point?
A bond dealer might.
Remember, in the bond markets deals may often be,
say, $200m at a time. If you could make 0.8 of a basis
point (pa) on a $200m deal, thats $16,000 (pa).
Comparative statics
If ytm increases, then P
0
decreases.
If ytm decreases, then P
0
increases.
A higher C produces a higher P
0
.
A lower C produces a lower P
0
.
When the price is calculated an instant after a coupon
payment:
if ytm < c, then P
0
> Par
if ytm > c, then P
0
< Par
if ytm = c, then P
0
= Par
Note: These relationships are not necessarily true if the
price is calculated at a time between coupon dates.
3. Bond Pricing in Practice (A):
Australian Conventions
Bond Pricing in Practice (A): Australian
Conventions
The bond pricing formula we have been using is a
textbook version.
It is a simplification of reality in three main respects:
1. It assumes annual coupons.
But Australian government bonds pay half-yearly
coupons
2. It assumes that the first coupon will be paid exactly one
year from the pricing date.
So it can be used only twice a year for Australian
government bonds.
3. It assumes that bonds are paid for (settled) on the same
day that the transaction is done (the trade date).
But for most Australian government bonds the
settlement date is a few days after the trade date.
We require a formula that will take account of these three
features (and some others too).
The formula we will develop is the one used by the
Reserve Bank of Australia and the Australian Financial
Markets Association.
Conventions
f
h
0 1 2 n-1 n
h =number of days in the half-year ending on the next coupon payment
f =number of days from the settlement date to the next coupon payment date
-1
$C $C
$C $C +
Par
Time Line for Coupon Bond with n Coupons Remaining
Conventions
Viewed from the payment date of the first coupon:
this is an annuity-due of n cash flows of $C, plus Par.
equivalently, it is an immediate cash flow of $C plus an
ordinary annuity of n 1 cash flows of $C, plus Par.
We will use the second of these descriptions.
Conventions
Using the second description, given a yield of ytm per half-
year, the value as at time 1 is:
We now need to discount V
1
back to time 0.
The length of this period is f / h of a half-year.
Therefore:
( ) ( )

(
= + + (
+ +
(

1
1 1
1
1
1 1
n n
C Par
V C
ytm
ytm ytm
( )
=
+
0 1
/
1
1
f h
P V
ytm
Conventions
Putting both parts together, we get the RBA pricing formula for coupon
bonds:
where:
ytm is the yield to maturity per half-year
n is the number of half-yearly coupons to be received
C is the half-yearly coupon
Par is the par (face) value of the bond
f is the number of days from the settlement date to the next coupon
payment
h is the number of days in the half-year ending on the next coupon
payment date
( ) ( ) ( )

(

= + + (
`
+ + +
(

)
0
/ 1 1
1 1
1
1 1 1
f h n n
C Par
P C
ytm
ytm ytm ytm
Conventions
Seven further technicalities:
1. In trading and reporting, the yield will be quoted per year (not
per half-year):
the quoted yield (pa) will be 2 ytm.
2. The coupon rate (c) is also stated on an annual basis. Therefore:
3. For bonds with more than 6 months to run to maturity, the
settlement date is 3 business days after the trade date. Non-
business days are Saturdays, Sundays and days that are public
holidays in both Sydney and Melbourne. All other days are
business days.
4. The price (per $100 par value) is taken to 3 decimal places.
=
1
2
C c Par
Conventions
Seven further technicalities (contd.):
5. There is an ex-interest period beginning a week (7 days)
before every coupon date.
If a bond is bought during that week (that is, if the trade
date falls in that week), the buyer is not entitled to receive
the next coupon.
So, delete the first C from the pricing equation.
6. If the first coupon payment date falls on a non-business day (eg
on a Saturday or a Sunday), then:
f is calculated as the number of days from the settlement
date to the first business day after the next coupon date but
h is calculated as the number of days in the half-year
ending on the next coupon date.
Conventions
Seven further technicalities (contd.):
7. When a bond goes ex-interest for the second-last time (ie 6 months plus
7 days before maturity), the cash flows consist of a single payment at
maturity, which is equal to the par value plus one half-yearly coupon.
- To maintain consistency with the procedures for Treasury notes and
other short-term securities, simple interest is used.
- Also, for these bonds, the settlement date is:
for trades completed before 12.00 noon, the same day;
for trades completed after 12.00 noon, the next business day.
Conventions
Seven further technicalities (contd.)
Example of the 7
th
Technicality
At 2.00 pm on Friday 2 September 2011, price a 6.5% February 2012 bond if
the yield is 4.850% pa.
Answer
Settlement date = next business day = Monday 5 September 2011.
Maturity date = Wednesday 15 February 2012.
Term = 25 + 31 + 30 + 31 + 31 + 15 = 163 days.
Coupon = $3.25.
=
+
=
0
$103.25
163
1 0.0485
365
$101.061(to 3 decimal places)
P
Conventions
Example of the Main Formula (Slide 8.31)
On Thursday 9 June 2011, The Australian Financial Review
reported that on Wednesday 8 June 2011 the market
yield on the 6.00% February 2017 Commonwealth
Government bond was 5.115% pa.
If the par value was $10,000,000 what was the bond
price?
Conventions
Answer:
The settlement date is Wednesday 8 June 2011 + 3 business days.
Monday 13 June 2011 was a public holiday in Sydney and Melbourne.
So the settlement date is Tuesday 14 June 2011.
The previous coupon date
= + + =
= + + + + + + =
= =
= =
=
was 15 February 2011.
The next coupon date is Monday 15 August 2011 (which
is a business day).
16 31 15 62 days
13 31 30 31 30 31 15 181 days
1
6.00% $100 $3.00 phy
2
1
5.115% pa 2.5575% phy
2
12
f
h
C
ytm
n coupon payments
Conventions
( ) ( ) ( )
( ) ( ) ( )
( )

(

= + + (
`
+ + +
(

)

(

= + +
(
`
(

)
= + +
=
0
/ 1 1
62/181 11 11
1 1
1
1 1 1
1 $3.00 1 $100
$3.00 1
0.025575
1.025575 1.025575 1.025575
0.991386960 $3.00 $28.45072348 $75.74575824
0.991386960 $10
f h n n
C Par
P C
ytm
ytm ytm ytm
=
=
=
7.1964817
$106.273 (to 3 decimal places)
$10, 000, 000
$106.273
$100
$10, 627, 300
P
Conventions
Most government bond trading in Australia is wholesale over-
the-counter (eg interbank) rather than retail.
Although the Reserve Bank operates a trading service for
retail clients (face values between $1000 and $250,000).
- See www.rba.gov.au/fin-services/bond-facility/
The wholesale market for Australian Government bonds is very
liquid.
Turnover is often once in every 2 to 6 weeks.
The next two slides gives details of trading for one (randomly
selected) day.
Conventions
Bond Turnover 7 June 2011
Bond series Turnover $m
Total on
issue $m
% Turn-
over
Turnover = once
every
5.75% Jun 2011 175 11199 1.56% 64 days
5.75% Apr 2012 474 14055 3.37% 30 days
4.75% Nov 2012 1698 8900 19.08% 5 days
6.50% May 2013 1638 16698 9.81% 10 days
5.50% Dec 2013 605 9300 6.51% 15 days
6.25% Jun 2014 561 11899 4.71% 21 days
4.50% Oct 2014 1507 8450 17.83% 6 days
6.25% Apr 2015 223 13348 1.67% 60 days
4.75% Jun 2016 515 9550 5.39% 19 days
Conventions
Bond Turnover 7 June 2011 (contd.)
Bond series Turnover $m
Total on
issue $m
% Turn-
over
Turnover = once
every
6.00% Feb 2017 23 13748 0.17% 598 days
5.50% Jan 2018 230 3500 6.57% 15 days
5.25% Mar 2019 215 13248 1.62% 62 days
4.50% Apr 2020 910 14297 6.36% 16 days
5.75% May 2021 759 12050 6.30% 16 days
5.75% Jul 2022 366 7400 4.95% 20 days
5.50% Apr 2023 53 1000 5.30% 19 days
TOTAL 9952 168642 5.90% 17 days
Source: Reserve Bank of Australia, published in The Australian Financial Review, 9 June 2011, p.40.
Conventions
4. Bond Pricing in Practice (B):
US Conventions
Recall that the textbook formula is:
In US terminology, this is called the flat price.
Also known as the clean price when quoted per $100 par
value.
Taken literally, it is the price of the bond exactly half a year
before the next coupon.
Bond prices reported in newspapers are typically clean
prices.
( ) ( )
0
1
1
1 1
T T
C Par
P
ytm
ytm ytm
(
= + (
+ +
(

Bond Pricing in Practice (B): US Conventions
As time passes since the last coupon payment date, the amount
of accrued interest grows.
The amount of accrued interest (I) is measured by:
The invoice price (ie the price paid by the buyer) is equal to the
flat price plus the accrued interest.
Also known as the dirty price when quoted per $100 par
value.
=
Days since last coupon payment
Days between coupon payments
I C
For US Treasury bonds:
Coupons are paid every 6 months.
Pricing is in 32nds of a dollar.
Settlement is one business day after the trade is agreed.
Accrued interest is calculated using actual day counts (ie not
assuming a 360-day year).
Example
Today is 12 September 2011. The flat price is $108:4. The
coupon rate is 6.25% pa. The last coupon was paid on 15
August. What is the invoice price?
Answer
The flat price is $108:4 = $108 4/32 = $108.125.
The half-yearly coupon = x$6.25 = $3.125.
Days from 15 August to 13 September = 29
Days from 15 August to 15 February = 184
= +
= +
=
Invoice price Flat price Accrued interest
29
$108.125 $3.125
184
$108.617527
5. The Yield Curve
The Yield Curve
The yield curve plots yields-to-maturity (vertical axis) for
coupon bonds against their terms to maturity (horizontal axis).
It is frequently referred to by practitioners, in the financial
press, in academic research etc.
The yield curve is typically close to, but is rarely coincident
with, the zero rate curve.
4.600
4.700
4.800
4.900
5.000
5.100
5.200
5.300
5.400
0 1000 2000 3000 4000 5000
%

p
a
Days to maturi ty
Austral i an Yi el d Curve 8 June 2011
The Yield Curve
Term
(years)
Zero rates
% pa
Coupon bond
yields % pa
Zero rates
% pa
Coupon bond
yields % pa
1 8.500 8.500 8.500 8.500
2 9.500 9.479 7.500 7.520
3 9.950 9.916 6.950 6.986
4 10.250 10.203 6.650 6.696
5 10.300 10.255 6.600 6.642
Example
Coupon = 4% pa
The Yield Curve
Rising zero rates:
Yields are less
than zero rates
Falling zero rates:
Yields are greater
than zero rates
The Yield Curve
If all bonds have the same coupon rate (4%), then:
Zero rates rising
Zero rates falling
Yields if coupon = 4%
(not to scale)
All zero rates equal
Zero rates = Yields
Term to maturity
%
pa
Term
(years)
Zero
rates
% pa
Yield %
pa if
coupon
= 4%
Yield %
pa if
coupon
= 16%
Zero
rates
% pa
Yield %
pa if
coupon
= 4%
Yield %
pa if
coupon
= 16%
1 8.500 8.500 8.500 8.500 8.500 8.500
2 9.500 9.479 9.429 7.500 7.520 7.568
3 9.950 9.916 9.840 6.950 6.986 7.067
4 10.250 10.203 10.106 6.650 6.696 6. 793
5 10.300 10.255 10.169 6.600 6.642 6.736
Rising zero rates:
Higher coupons
decrease yields
Falling zero rates:
Higher coupons
increase yields
The Yield Curve
Zero rates rising
Zero rates falling
(not to scale)
Zero rates flat
Zero rates = Yields
Term to maturity
%
pa
The Yield Curve
The Yield Curve
Now suppose that the only bonds traded in this market are
1-year 16% coupon bonds
4-year 4% coupon bonds and
What will the yield curve look like?
The Yield Curve
% pa
Zero rates
Yields (4%
coupon)
Yields (16%
coupon)
Term (years)
2 3 4 5
1
X
X
X
X
X
Is this bond
wrongly priced?
The Yield Curve
Even though the zero rate curve is smooth, the observed
yield curve has lumps and bumps in it.
The yield curve may, of course, even give two (or more) yields
for the same term to maturity
in the example, the yield on the 3-year 4% coupon is
9.916% pa while the yield on the 3-year 16% coupon is
9.840% pa.
So, lumps and bumps in a yield curve may indicate:
Nothing much its just how it is, due to different bonds
having different coupon rates.
Data problems (eg yields are taken from trades that
occurred at slightly different times).
Market inefficiency (some yields are wrong).
6. The Par Yield Curve
In some countries (like the US) there are so many different
bonds on issue that inevitably some will be selling at par on a
coupon date.
Such a bond is called a par bond
and its yield is called the par yield.
From these bonds we can estimate the par yield curve.
And it turns out that from the par yield curve we can find the
zero rate curve.
which, in turn, can then be used to price a wide range of
securities.
The Par Yield Curve
The Par Yield Curve
( )
( ) ( )
( )
( ) ( )
( )
+
= + + +
+
+ +
=
(
+
= + + + (
+
+ +
(

= + + + + (

0
2
01
02 0
0
2
01
02 0
0 01 02 0
We can write the price of any bond as:
...
1
1 1
Recall that: .
1
...
1
1 1
It's easier to use discount factors:
... 1
T
T
T
T
T
C C Par C
P
z
z z
C c Par
c c c
P Par
z
z z
P Par d c d c d c
The Par Yield Curve
( )
( )
( )
( )
= + + + + (

+ + + + =
=
+ + + + = =
+ + + + =
=
0 01 02 0
0
01 02 0
0
0
01 02 0
01 02 0 0
0
0
... 1
Therefore: ... 1
For a par yield bond, we know that = and :
... 1 1
Hence: ... 1
1
So:
T
T
T
T T
T
T
P Par d c d c d c
P
d c d c d c
Par
P Par ytm c
P
d ytm d ytm d ytm
Par
ytm d d d d
d
ytm
d + + +
1 02 0
...
where means yield to maturity on a -year par yield bond.
T
T
d d
ytm T
Example
Suppose we observe bonds selling at par for terms of 1, 2, 3, 4
and 5 years. Their yields to maturity (ytm) are:
1 Year: 7.100% pa
2 Years: 7.750% pa
3 Years: 8.125% pa
4 Years: 8.300% pa
5 Years: 8.400% pa
What are the discount factors for terms of 1, 2, 3, 4 and 5 years?
Hence, what is the price (per $100 par) of a 5-year 10.5% bond?
The Par Yield Curve
Answer
= =
01
1
By definition 0.933706816
1.07100
d
02
2
01 02
02
02
02
1
When 2, we have .
1
Hence 0.07750 .
0.933706816
Solving, we find 0.860916679.
d
T ytm
d d
d
d
d
= =
+
=
+
=
The Par Yield Curve
Answer (contd.)
Similarly, we find:
d
04
= 0.725278209 and
d
05
= 0.666022424
The Par Yield Curve
03
3
01 02 03
03
03
03
1
When 3, we have .
1
Hence 0.08125 .
0.933706816 0.860916679
Solving, we find 0.78999939.
d
T ytm
d d d
d
d
d
= =
+ +
=
+ +
=
Answer (contd.)
Therefore, the price (per $100 par value) of a 5-year 10.5%
bond is:
+ +
+ +
=
0.933706816 $10.50 0.860916679 $10.50 0.78999939 $10.50
0.725278209 $10.50 0.666022424 $110.50
$108.3494393
The Par Yield Curve
The Par Yield Curve
How is the par yield curve related to the zero rate curve?
If the zero rate curve is flat, then the par yield curve is also flat
(coincident).
If the zero rate curve is upward sloping, then the par yield
curve is also upward sloping but lies below the zero rate curve.
If the zero rate curve is downward sloping, then the par yield
curve is also downward sloping but lies above the zero rate
curve.
The Par Yield Curve
Zero rates rising
Zero rates falling
Par yield curve
Par yield curve
(not to scale)
All zero rates equal
Par yield curve
Term to maturity
%
pa
7. Finding the Zero Rate Curve:
Bootstrapping
Finding the Zero Rate Curve: Bootstrapping
Recall, in practice, few zero coupon bonds are traded so we
cant observe the zero rate curve.
Another way to find the zero rate curve that lies hidden
behind the observed market prices of the various coupon
bonds is bootstrapping.
Suppose we are able to observe the market prices of three
coupon bonds that are exactly 1, 2 and 3 years before their
respective maturity dates.
To keep it simple, we will also assume that these bonds pay
annual coupons.
To show how this works we will use the following new
notation:
0,
is the price of a -year bond at time 0.
is the coupon paid on a -year bond.
T
T
P T
C T
We can solve this sequentially.
( )
( ) ( )
+
=
+
+
= +
+
+
+
= + +
+
+ +
1
0,1
01
2 2
0,2
2
01
02
3 3 3
0,3
2 3
01
02 03
100
1
100
1
1
100
1
1 1
C
P
z
C C
P
z
z
C C C
P
z
z z
( )
( ) ( )
+
=
+
+
= +
+
+
+
= + +
+
+ +
1
0,1 01
01
2 2
0,2 02
2
01
02
3 3 3
0,3 03
2 3
01
02 03
100
1
100
1
1
100
1
1 1
C
P z
z
C C
P z
z
z
C C C
P z
z
z z
Example
We observe the following bond yields:
1-year bond with 12% coupon: 9.65% pa
2-year bond with 9.75% coupon: 10.174% pa
3-year bond with 6.50% coupon: 10.351% pa
Use bootstrapping to identify the zero rate curve.
Answer
The 1-year bond is effectively a zero. So z
01
= 9.650% pa.
Using the bond yields, we calculate bond prices (per $100
par value) as follows:
( )
( ) ( )
= + =
= + + =
0,2
2
0,3
2 3
$9.75 $109.75
$99.265847
1.10174
1.10174
$6.50 $6.50 $106.50
$90.482004
1.10351
1.10351 1.10351
P
P
Answer
( )
( )
( )
( )
( )
= = +
+
=
+
= =
= = + +
+
=
0,2
2
02
2
02
0.5
02
0,3
2 3
03
03
$9.75 $109.75
$99.265847
1.0965
1
$109.75
$90.373918
1
1.2143990 1 10.200% pa
$6.50 $6.50 $106.50
$90.482004 ,
1.0965
1.102 1
which solves to give 10.375% pa.
P
z
z
z
P
z
z
8. The Holding Period Return
The Holding Period Return
Recall that a zero-coupon bond held until maturity is certain
to achieve a rate of return equal to the zero rate.
This is not true of a coupon bond.
Consider a 2-year coupon bond:
The rate of return that will be achieved depends on z
12
, which
today (time 0) is unknown.
0 1 2
P
0
+ C + 100 + C
+(1+ z
12
)C
This is an example of the reinvestment rate problem.
The holding period return (ie the return actually achieved) on a
coupon bond held to maturity depends on the future interest
rate(s) that will be earned on the coupon payments.
Because reinvestment rates are unknown (ex ante), the holding
period return on a coupon bond may be greater than, or less
than, its yield.
If a coupon bond is not held to maturity, then of course the
holding period return also depends on the price received when
the bond is sold in the future, which is also unknown today.
An important special case
IF:
1. A coupon bond is held to maturity and
2. Future reinvestment rates are known today and are constant
and
3. This reinvestment rate happens to equal the yield to maturity,
THEN:
The holding period return is also equal to the yield to maturity.
That is, HPR
0T
= ytm.
Proof
( ) ( )
(
= + (
+ +
(

| |
=
|
\ .
0
1/
0
0
1
1 (1)
1 1
1 (2)
where is the sum accumulated at time .
In the present case, is the future value of an
ordinary annuity of where the interest rate i
T T
T
T
T
T
T
C Par
P
ytm
ytm ytm
S
HPR
P
S T
S
C
( )
(
= + +

s ,
plus the par value.
1 1 (3)
T
T
rr
C
ie S rr Par
rr
Proof (contd.)
( )
( ) ( )
( )
=
(
= + +

(
+ = + +

= +
| |
=
|
\ .
0
0
1/
0
If , then (3) becomes:
1 1 (4)
From (1) it follows that:
1 1 1 (5)
The right-hand sides of (4) and (5) are the same.
Therefore:
1
T
T
T T
T
T
T
T
rr ytm
C
S ytm Par
ytm
C
P ytm ytm Par
ytm
S P ytm
S
ytm
P
( )
=
0
1
see equation ( 2)
T
HPR
If it turns out that coupons can be reinvested at a higher (lower)
rate than the yield, then the holding period return will be higher
(lower) than the yield.
Practical implication
If you expect interest rates to increase (decrease) in the long
term, and you hold bonds until maturity,
then the rate of return you will achieve will be higher (lower)
than the current yield.

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