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)