Lecture 1

Introduction and Bond Pricing

Lecturer
Teachers
The first part of the course is taught by Joakim
Bang
Consultation hours Mondays 11 to 1 in ASB 311

You can reach me (in preferred order) on:

The blackboard discussion forum
Email: j.bang@unsw.edu.au

The second part of the course is taught by Sid

Sahgal
Consultation hours and contact details TBA

Textbook
We use Bodie, Kane and Marcus Investments,
9th edition
You may or may not get by with an earlier
edition of the book
Everything will be covered in the lectures
If you want to do additional exercises, you
may want to buy the solution manual
associated with the book

Lectures
Each lecture will have a corresponding thread
on the blackboard discussion forum
For each lecture, the course outline lists
essential readings (which you should really try
to read before the lecture) and recommended
readings (which is good to read before the
lecture)

Tutorials
There are weekly tutorials
Exercises for each tutorial will be posted on
blackboard
You should try to solve the questions yourself
before watching the tutorial

Online Quizzes
Every lecture comes with an online quiz that
counts towards your final grade
You get a maximum of three attempts, with the
highest score counting
Theres a total of 11 quizzes, counting for a total
of 11 % of your final grade
The quiz deadlines are given in the course outline
Please make sure to meet the deadlines.
Extensions will only be given in exceptional
circumstances.

Computer assignment
The assignment is to be submitted via blackboard
on May 6
You should also email me a copy of your solution
(as a backup in case something goes wrong with
your blackboard submission)
The assignment is solved in groups of up to three
students. You may form smaller groups, but the
total workload remains the same
The assignment counts for 10 % of the final grade

Exams
The midterm counts for 37% of the grade
Its given on the weekend after week 7

The final exam counts for 37% of the grade

Its given on UNSW campus in the summer term
examination period

Top Hat Monocle

Were trying out some software to submit
anonymous feedback during the lecture
You can do this via your pad or phone
Please read the student instructions posted on
blackboard on how to do this

First topic: Bond pricing

We will approach this topic a bit differently than
the textbook
Specifically, we will be explicit about how
arbitrage pricing allows use discounting to price a
bond
The lecture notes will give you a good
understanding about what is relevant for the
midterm
Some of the extensions in the textbook will be
covered in the tutorial sessions

What is a bond?
A claim on some fixed future cash flow(s), CF.
The bond matures at the time of its last cash
flow, T.
Typically a large cash flow at maturity. We
call this the par value or face value (FV).
There may be a series of smaller cash flows
before maturity. We call these coupons.
There may be zero, one or more coupons in a
given year.

What is a bond?
The sum of the annual coupons are often
expressed as a fraction of the FV, e.g. 5 %. We
call this the coupon rate (C). Lets denote the
actual coupon, e.g. $5, with ct, where t is the
period in which we get the coupon.
A bond with no coupons is called a zerocoupon bond

Cash flows of a bond

This figure illustrates the cash flows of a bond
with a FV of 100 and a yearly coupon of 5
-P

c1

c2
FV

-91.3

5
100

Default risk
That somebody promises to pay you some
money doesnt necessarily mean they will
The risk that you will be unable to collect your
cash flows is called default risk
This is very important in practice, but we will
generally ignore it in this course

Other frequent assumptions

No transaction costs
Constant interest rates
Complete markets
These are all true within our model
Compare this to the assumption of vacuum in
classical mechanics

Two approaches to pricing

Fundamental pricing
Prices are set in a supply-demand equilibrium
The properties of an asset tell us what that price is
likely to be
We will use this approach when pricing stocks later in
the course

Arbitrage pricing
Take some price as given and price other assets
relative to that
We will use this approach when pricing bonds and
derivatives

What is arbitrage?
An arbitrage is a (set of) trades that generate zero cash
flows in the future, but a positive and risk free cash
flow today
This is the proverbial free lunch or money machine
A simple example exploits violations of the law of one
price, e.g. an identical bond selling for two different
prices
Simultaneously buying the cheap bond and selling the
expensive bond would be an arbitrage trade

All arbitrage pricing is priced based on the same

principle, but the trades are (slightly) more complex

Replicating portfolios
We typically rely on a portfolio of assets that
exactly mimic the cash flows of some other
asset
We call such portfolios replicating portfolios
or synthetic assets
Arbitrage pricing is all about constructing
replicating portfolios using assets with known
prices

Example: Pricing a zero-coupon bond

How would you price the risk-free one-year
zero-coupon bond below?
Bond A
100

Example: Pricing a zero-coupon bond

You may already know how to discount the
future cash-flow with some appropriate
discount rate, y, to get the present value
Assuming that r = 10% youd get
100
100
PA

90.9
1 y 1.10

What is the economic logic behind this?

Where does the discount rate come

from?
The appropriate discount rate, y, is the return
we could have earned at some alternative
investment with the same risk
Lets say theres a bank where you can lend
and borrow money at 10% interest
Suppose the price of Bond A was actually
$80.9, i.e. lower than what we found on the
last slide

Constructing a replicating portfolio

We know that the bond is mispriced. How do we exploit
this?
We want to make a synthetic version of the bond, i.e. some
investments that mimic its cash flows exactly
In this simple example we can just put some amount of
money, M, in the bank.
How large must M be?
After one year in the bank account earning 10% interest, it
should have grown to match the bonds cash flow of $100
We must have
1.1M 100
100
M
90.9
1.1

Exploiting the mispricing

The $90.9 bank deposit replicates the bonds cash
flow (is a synthetic bond) but has a different price
We buy the cheap instrument and sell the
expensive (in this case the synthetic) instrument
Selling a bank deposit means borrowing the
money
Short selling (or shorting) strategies or instruments in
this way is often an important part of arbitrage pricing

What are our cash flows?

Today we borrow $90.9 and buy the bond for
$80.9. We are left with $10.
In one year the bond pays us $100 which is
exactly enough to repay the loan. We have
zero net cash flow.
Our free $10 is an arbitrage profit and the
entire scheme is an arbitrage trade

Arbitrage pricing
In practice smart people will identify arbitrage
opportunities and trade on them
This will increase the demand for the bond and
raise its price until no further arbitrage trades are
possible, i.e. until prices are in equilibrium
In this course we are interested in finding those
equilibria, e.g. arbitrage-free prices
We can not say whether it was the bond price or
the banks interest rate that was wrong
We can only say (and only care) if the prices are
internally consistent

How do we find the price of our bond?

-P

5
100

Strategy: Replicate the entire CF-stream we

want to price
For there to be no arbitrage the price of the
CF-stream must be the same as the price of
the replication

How do we find the price of our bond?

Think of the bond as two zero-coupon bonds
Replicate each bond by depositing money in the
bank, as before
Together, our two deposits will form a replicating
portfolio
Note that the interest rate we get for a two year
deposit may be different from that of a one year
deposit
To indicate the maturity of an interest rate we
typically use a time index: yt

How do we find the price of our bond

We want to replicate a cash flow of c at time T = 1
Observe some interest rate, y1, that is valid over the time
[0,1]
Today, deposit M1 such that M1(1 + y1) = c
Find that M1 = c/(1 + y1)

We want to replicate a cash flow of FV + c at time T = 2

Observe some interest rate, y2, that is valid over the time
[0,2]
Today, deposit M2 such that M2(1 + y2)2 = FV + c
Find that M2 = (FV + c)/(1 + y2)2

Our complete strategy costs

M1 + M2 = c/(1 + y1) + (FV + c)/(1 + y2)2

Discounting
We say that P is the present value, PV, of the
future cash flows
This process of calculating the PV of future CFs
is called discounting
The market determines the appropriate
interest rates, y1 and y2
We are typically not explicit with the entire
arbitrage argument

Discounting and prices

The price of a bond (or indeed any financial
asset) is the sum of the present values of its
future cash flows.
The price of a bond (or indeed any financial
asset) is the sum of the present values of its
future cash flows. Thats worth repeating.

Pricing formula and yield-to-maturity

When we have many CFs, discounting each
one gets tedious
It would be useful with a compact pricing
formula
To get one we will assume that interest rates
are constant, i.e. yt = y for any t
We also have to introduce the concept of
perpetuities

Perpetuities
A perpetuity is a never ending constant cash flow
stream, e.g. an annual payment of c
How do we value such a thing? Set up a
replicating portfolio
Lets deposit some amount of money, M, in the
bank and withdraw the interest every year
How large would M have to be in order to give an
interest of c?
My c
M

c
y

What do we want to replicate?

One coupon stream (of c) from 1 to T
One large payment (of FV) at T
The present value of the FV is easy
PV(FV) = FV/(1+y)T

The coupon stream, CS, can be viewed as the

difference between two perpetuities:
One perpetuity starting at time 1, X1
One perpetuity starting at time T+1, X2

Its PV is the difference in the PV of X1 and X2

PV(CS) = PV(X1) - PV(X2)

Replicating the coupon stream

The coupon stream, CS, can be viewed as the
difference between two perpetuities:
One perpetuity starting at time 1, X1
One perpetuity starting at time T+1, X2

Its PV is the difference in the PV of X1 and X2

PV (CS ) PV ( X 1 ) PV ( X 2 )
PV (CS )

c c

y y

1 y T

c
1
1

y 1 y T

Pricing formula and yield-to-maturity

Adding the PV of the coupon stream and FV we get our
pricing formula:
c
1
FV
P 1

y 1 y T 1 y T

Note that in practice interest rates are not constant

Instead we take P as given and define y as whatever
interest rate satisfies the equation above. Expressed on
an annual basis, we call this interest rate the yield-tomaturity (YTM, although we often just denote it y).
Each bond has its own YTM

YTM and bond prices

This graph shows the price of a 30-year bond
with a FV of $100 and a coupon rate of 10 %
for different YTMs
350
300

Price

250

200
150
100
50
0
0%

5%

10%

15%
YTM

20%

25%

YTM and bond prices

The bond price decreases with the YTM
The price is less sensitive to changes in the
YTM when the YTM is high
When YTM = C = 10 %, P = FV = $100
When P = FV (C = YTM), the bond trades at par
When P < FV (C < YTM), the bond trades at a
discount
When P > FV (C > YTM), the bond trades at a
premium

Realized compound yield

Bond A

2
FVA

Bond B

c
FVB

Suppose that the two bonds above have the

same YTM
For a given investment the time two cash flows
will differ, since bond B pays a coupon at time 1
That coupon will have to be reinvested to make
the time two cash flows comparable

Realized compound yield

If the coupon can be reinvested at an interest
rate that equals the YTM, the time two cash
flows will be equal
The realized compound yield is a useful
concept when the reinvestment rate is
different from the YTM
Collect all cash flows at the maturity of the bond
Solve for the annualized return by dividing by the
price

Example: Realized compound yield

A bond maturing in 2 years has a face value of $100
and pays an annual coupon of $10
The price is $96.62, so the yield to maturity is 12%
Suppose we can reinvest the coupon at 10%
The resulting cash flow at time 2 would be CF2=100 +
10 + 10(1+0.1) = 121
The realized compound yield would be
y

121
1 11.9%
96.62

We will be very interested in such reinvestments in the

next lecture

An alternative interpretation of the

YTM
Suppose you could reinvest all coupons at an
interest rate that equals the YTM
The realized compound yield, i.e. your
investment return at the maturity of the bond,
would equal the YTM
Although this is a common interpretation of
the YTM, the concept does not make any
assumptions on reinvestment rates

Current yield
You may hear about a bonds current yield
This simply means the bonds annual coupon
divided by its price