types of bonds -
- issued by gov't >> gov't bonds
- issued by firms >> corporate bonds
- risk premium - difference between interest rate paid and interest rate paid on best rated bond
- junk bond - high default risk
- discount bond - offers single payment (face value) at maturity
- coupon bond - offers multiple payments before maturity, another payment at maturity
- coupon payments - payments before maturity
- face value - final payment at maturity
- coupon rate - ratio of payments to face value
- current yield - ratio of payment to price of bond
- treasury bills (T-bills) - gov't bonds w/ maturity of 1 year
- price equal to payment in terms of present values
- $Pt = payment / (1+it)
- treasury notes - maturity of 1 to 10 years
- treasury bonds - maturity of 10 or more years
- indexed bonds - payments adjusted for inflation
bond characteristics -
- default risk - risk that firm issuing bond will not pay full amount
- maturity - length of time over which bond makes payments
- yield curve (term structure of interest rates) - relation between maturity and yield of bond
arbitrage - comparing expected returns
- 1 year bond >> worth $M (1+it) next year
- 2 year bond >> worth $M (Pt+1/P2t)
- Pt+1 = price expected to be sold next year
- P2t = price of 2 year bond
- same expected 1 year return >> (1+it) = (Pt+1/P2t)
- P2t = Pt+1 / (1+it)
- price of 2 year bond equal to expected bond price next in present values
- Pt+1 = (final payment) / (1+it+1)
- expected bond price relates to expected interest rate
- P2t = (final payment) / [(1+it)(1+it+1)]
- P2t = (final payment) / (1+i2t)2
- (1+i2t)2 = (1+it)(1+it+1)
- i2t ~ (1/2)(it + it+1)
Subject:
Subject X2:
