FINS2624 – Portfolio Management

Semester 1, 2011

LECTURE 1 – BOND PRICING

WHAT IS A BOND?

A bond is a claim on some fixed future cash flows. A commonwealth government bond (CGB) is a bond which pays semi-annual coupons, in which the maturity date/ coupon payment date is on the 15th of every month. A zero coupon bond is a bond with no coupons. The important information of a bond: 1. 2. 3. 4. 5. 6. • 1. 2. Transaction date: T Settlement date:T+2 Coupon payment dates Maturity date YTM Coupon rate Cum-interest or Ex-interest? If ex-interest If> 7 days to the next coupon payment-----> cum-interest

YIELD TO MATURITY

The Yield to Maturity (YTM) of a bond is: Interest rate that makes the present value of the bond’s payments equal to its price. Determined by the market, reflecting annual rate of return required by market.

The Relationship between YTM and Bond Price: YTM = Price AND Price Sensitivity YTM = Price AND Price Sensitivity When YTM = C = 10%, P = FV = $100 o C = YTM, P = FV – Par Bond o C < YTM, P < FV – Discount Bond o C > YTM, P > FV – Premium Bond

NO ARBITRAGE PRINCIPLE

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 done through the violation of law of one price. An arbitrage trade is done by selling the real instrument, and buying a synthetic instrument (replicating strategies or portfolios). By constructing a synthetic bond and buy the under-priced real bond and selling 1

Cheryl Mew

FINS2624 – Portfolio Management

Semester 1, 2011

overpriced synthetic bond, an arbitrage opportunity exists, where people can earn money, whilst not incurring any risk. In Fins 2624, we employ the No Arbitrage Principle – i.e. same bonds will have the price.

BOND PRICING

The value of a bond (like any financial security) is the present value of all future cash flows. A bond produces two different cash flows: Coupon payments