Theory of Finance

Lecture 2

Market for discount and coupon bonds II

I Introduction

In the previous lecture we discussed how a financial analyst can assess the degree of price
risk1 by looking at the difference between a long-term government yield and a short-term
government yield (= government spread). Below is a reproduction of the table with yields
and spreads on 3-month, 2-year and 10-year government debt securities from US, UK, and
Euroland we discussed in the previous tutorial.

Table 1 – Price risk and default risk as of 08 January 2016

US (Bills/Notes) UK (Bills/Gilts) EU (ST/LT)

Yield % Spread % Yield % Spread % Yield % Spread %
3M Gov 0.20 0.13 -0.48
2Y Gov 0.94 0.74 0.53 0.40 -0.39 0.09
10Y Gov 2.13 1.93 1.84 1.31 0.68 1.16
10Y Corp 3.84 1.71 2.96 1.12 - -

In addition to assessing the degree of price risk a financial analyst can assess the future
prospect of economy by looking at these yields. For this purpose it is more convenient to
plot the yields graphically in the “yield – time to maturity” plane.

This is the first topic of the lecture. The second topic of the lecture covers redemption yield
/ yield to maturity for coupon bonds.

II Yield curve: graphical shapes and economic interpretations

In addition to the UK Treasury yields for a 3-month, 2-year and 10-year maturity we add
the UK Treasury yields on a 1-year, 4-year, and 6-year maturity as given in Table 2.

Table 2 – UK government yields for different maturities, %

3M 1Y 2Y 4Y 6Y 8Y 10Y
0.13 0.31 0.53 0.98 1.33 1.60 1.84

As time to maturity increases yield increases too. Graphical representation is given in

Figure 1.

1
Alternative names are interest rate risk and, in a lesser degree, inflation risk.
 y 2,0 10Y
1,8
8Y
1,6
1,4 6Y
1,2
4Y
1,0
0,8
0,6 2Y
0,4 1Y
3M
0,2
0,0
0,25 1 2 4 6 8 10
T

Figure 1 – Yield curve for the UK as of 08/01/2016

Yield curve (YC) depicts dependency of yield upon time to maturity. Do not get confused
here: T is not an indication that we move into the future. The picture is static as of
08/01/2016 and reproduces UK Treasury yields observed as of 08/01/2016 for different
time to maturity. Hence, while it is correct to say that the short-term interest rate
prevailing in the economy now is 0.13% it is incorrect to say that the short-term interest
rate prevailing in the economy in 10 years will be 1.84%. We simply don’t know what will be
the short-term interest rate prevailing in the economy in 10 years! 1.84% is a long-term
interest rate prevailing in the economy now.

However, a comparison of the current short-term yield and the current long-term yield
gives a hint as to evolution of the future short-term yield. While future short-term yields
are unknown the market has conditional expectation of future short-term yields. The
expectation is conditional upon the set of information available now. Forward rates are
conditionally expected future short-term interest rates.

Long-term interest rates are determined by short-term interest rates prevailing in the economy
now and conditional expectation by the market about evolution of future short-term interest
rates:

𝑦 + 𝑓2 + 𝑓3 + ⋯ + 𝑓𝑇
𝑦𝑇 ≈ .
𝑇

Here 𝑦𝑇 denotes a long-term (= for an investment horizon lasting T periods) interest rate
observed now, 𝑦 denotes a short-term (= for an investment horizon lasting 1 period)
interest rate observed now, 𝑓2 denotes a short-term (= for an investment horizon lasting 1
period) interest rate expected to be observed in period 2, 𝑓3 denotes a short-term (= for an
investment horizon lasting 1 period) interest rate expected to be observed in period 3 and
so on. All interest rates are expressed per period, e.g. per year. The above formula is only
an approximation. A precise formula is given in Section III. If market expects future short-
term interest rates to rise then, according to the formula, the current long-term interest
rate will be higher than the current short-term interest rate and the YC will be upward
sloping. By looking at the UK YC as of 08/01/2016 a financial analyst would draw a
conclusion that the market expected short-term interest rates to rise in the UK in the
future.

There are 5 commonly observed shapes of the YC in real markets. They are given in Figure
2. Economic interpretation of the shape of the YC is an important issue in financial analysis.
This is because Treasury yields can tell how the market feels about the economy.

Figure 2 – Shapes of the YC

Normal YC

A positive slope means that yields rise as maturities lengthen. Current long-term yields are
higher than current short-term yields and future short-term interest rates are expected to
rise.

A positive slope reflects market expectation of economic growth along and/or inflation
growth. First, this is because if interest rates are expected to increase in the future the
premium for price risk increases now. This elevates the long-end of the YC. Second, this is
because the expectation of inflation growth leads to the expectation that the monetary
authority (the Bank of England in the UK or the Federal Reserve in the US) will raise short-
term interest rates in the future to slow economic growth and dampen inflationary
pressure. Obviously, these two effects are interrelated.
Economic growth often goes along with inflation growth.2 Is it possible to have economic
growth without rising inflation? Is it possible to have rising inflation without economic
growth?

It is worth noting that it is possible to have low long-term US and UK Treasury yields even
under expectation of economic growth along with inflation growth. What limits the growth
of Treasury yields in the US and the UK? US and UK Treasuries are investment
opportunities not only for home investors but for outside investors. Hence, there is an
international factor. In time of flight to quality outside investors invest into US and UK
Treasuries which are largely regarded as safe. The increased demand on the long-end of
the YC causes long-term prices to rise and long-term yields to fall. An example is low yields
on UK gilts during the height of the European debt crisis in 2012 and during the
expectation of Euroland government bonds turning negative in 2015.

Inverted YC

An inverted YC means that current long-term yield is below the current short-term yield.
This points out that the market expects economic slow-down (= growth rates slows
down) or economic recession (= growth rates turns negative). “Smart money” moves
from risky assets to long-term government bonds in expectation of a worsening economy
because long-term government bonds are widely regarded as a “safe harbour”. Long-term
investors generate an excess demand at the long-end of the YC and push down long-term
interest rates. An inverted YC means that inflationary pressure will be low (= future short-
term interest rates are expected to decrease). A worsening economy is frequently associated
with low inflation.

In the US an inverted curve has indicated a worsening economy in the future 6 out of 7
times since 1970. The New York Federal Reserve regards it as a valuable forecasting tool in
predicting recessions 2 to 6 quartes ahead.

Flat YC

A flat YC means that current short-term yields and current long-term yields are similar.
This is not an indication of zero price risk premium since it makes no sense. A flat YC
indicates uncertainty in the economy. Market expectations vary and counterbalance one
another (= we sum up geometrically the normal YC and the inverted YC in Figure 2). When
uncertainty turns into certainty market expectation will consolidate and the YC will revert
either to a normal one or an inverted one.

Steep YC

A steep YC is positively sloped. Hence, market expects economic growth. However, with a
steep slope a gap between current short -term yields and current long-term yields is much
2
Very schematically we could describe the inflationary process as follows: high growth => more employment =>
labour shortages => fall in unemployment puts upward pressure on wages => demand rises faster than firms can
keep pace with supply => firms push up prices => inflation rises.
larger than for a normal YC. Hence, future short-term interest rates are expected to be
much higher. A steep YC is observed at the beginning of economic growth (= a sign of
the beginning of a bullish market) when an upswing trend begins rather than at the middle
of economic growth when an upswing trend is established. This is because at the beginning
of economic growth short-term interest rates are very low after having been pushed down
by economic downswing. Companies can borrow cheap and, hence, can expand their
businesses quickly. That reinforces economic growth. The UK YC has seems to have a steep
shape as of 08/01/2016 in the maturity segment from 3 months to 10 years (see Figure 1).

Humped / bell-shaped YC

A humped / bell-shaped YC points out to a possible switch from economic upswing to

economic downswing in the middle-run.

Note that for plotting the YC zero-coupon Treasury yields are to be taken. Coupon
Treasury yields can not be taken because coupons will have a distorting effect. The name of
the YC in Russian is “кривая бескупонной доходности”.

III Forward rates

The path of actual future short-term interest rates is unknown. Yet, by examining discount
prices and discount yields for different maturities it is possible to build a path of implied
future short-term interest rates. They are called forward rates. These are future short-term
interest rates implied by discount prices and discount yields (which are observable in a
market) through the pricing relationships discussed earlier.

Assume we invest £1 in a t-period discount bond. After t periods the value of the
investment accumulates to 1 𝐷𝑡 (see Table 3 in Lecture 1). Alternatively we invest £1 in a
t-1-period discount bond. After t-1 periods the value of the investment accumulates to
1 𝐷𝑡−1 . And then we reinvest 1 𝐷𝑡−1 for 1 period (from t-1 to t) at some unknown future
1-period interest rate 𝑓𝑡 to receive 1 + 𝑓𝑡 𝐷𝑡−1 after t periods. This is called a rollover
strategy.

Table 4 – A rollover strategy

Period 0 t-1 t
Investment in t-period strip £1 → → 1 𝐷𝑡
or t-1-period strip 1 + 𝑓𝑡
Investment in with a 1-year £1 → 1 𝐷𝑡−1 →
𝐷𝑡−1
rollover strategy

For the no-arbitrage principle to hold the two alternative investments are supposed to give
the same return:

1 1 + 𝑓𝑡
= ⟹
𝐷𝑡 𝐷𝑡−1
 𝐷𝑡−1
𝑓𝑡 = − 1, 𝑡 = 1, … , 𝑇. (1)
𝐷𝑡

Here 𝑓𝑡 is a forward rate for period t (= a one-period interest rate expected to hold from the
beginning of period t to the end of period t).3

As of 08/01/2016 the UK 1-year interest rate 𝑦1𝑌 was 0.31% (the 1-year discount price 𝐷1𝑌
was 0.9969) and the UK 2-year interest rate 𝑦2𝑌 was 0.53% (the 2-year discount price 𝐷2𝑌
was 0.9895). The interest rate for a 1-year period investment is smaller than the interest
rate for a 2-year period investment. Hence, the next year’s interest rate for a 1-year period
investment is expected to rise. Assume annual compounding. Let’s calculate it:

𝐷1𝑌 0.9969
𝑓2 = −1 = − 1 = 0.0075 = 0.75%,
𝐷2𝑌 0.9895

1
1 + 𝑦1𝑌 1 + 𝑦2𝑌 2 1 + 0.0053 2
𝑓2 = −1 = −1= − 1 = 0.0075 = 0.75%.
1 1 + 𝑦1𝑌 1 + 0.0031
1 + 𝑦2𝑌 2

A simple check gives:

1 + 0.0031 1 + 0.0075 ≈ 1.0106 ⟹ 1.0106 ≈ 1.0053 = 1 + 0.0053 .

In words, an investor is equally happy holding two 1-year bonds one after the other, as
holding one 2-year bond for two years. Hence, the expected return from these two
investment opportunities is to be equalised.

As in (7) in Lecture 1 an appropriate adjustment should be made in (1) for the case of
semiannual compounding. If 𝐷𝑡−1 and 𝐷𝑡 are discount prices half-year apart from each
other the resulting forward rate is also for a half-year period, that is:

𝑓𝑡 𝐷𝑡−1
= − 1, 𝑡 = 1, … , 𝑇. (1′)
2 𝐷𝑡

Discount yield and time to maturity are also appropriately adjusted: discounts yield half
decreases, time to maturity twice increases.

IV Redemption yield / yield to maturity for a coupon bond

In the previous lecture we studied how to value a discount bond in a single period and in
multiple periods. Then we studied how to value a coupon bond. A coupon bond can be
“stripped” (= decomposed) of its coupon payments and the face value repayment which can

3
Do not confuse period t (a span of time with a beginning and an end) and time t (a moment of time). If Dt is a
price of a discount bond to mature t periods from now it means t full periods from now (= to the end of period t).
For example, D1 is a price of a discount bond to mature at the end of period 1, not at the beginning of period 1
(which is simply today). At the same time, the forward rate is set at the beginning of period t.
be traded separately as discount bonds (= “zeros”). The reverse technique is also possible.
Hence, if prices of “zeros” (= discount prices) for different maturities are available, then
multiplying them by corresponding quantities and adding them up together will give the
price of a coupon bond. This is true as long as the no-arbitrage principle and the value
additivity principle hold. In other words, to obtain the price of a coupon bond we take all
coupon payments and the face value repayment, attach corresponding discount prices to
them and add them up together.

We see that “zeros” act as basic building blocks in this linear model. Now we will study its
alternative: a non-linear model of valuing a coupon bond. This is a yield-based model.

Recall from Lecture 1 that discount yield y is based on a geometric average of future
returns 𝑦 𝑝𝑒𝑟𝑖𝑜𝑑 1 , … , 𝑦 𝑝𝑒𝑟𝑖𝑜𝑑 𝑇 . The redemption yield / yield to maturity for a discount bond
is given by the following formula:

1
1 𝐷𝑇 − 1 = 𝐷𝑇−1
𝑇 𝑇 −𝑇
𝑦= − 1 ⟹ 𝐷𝑇 = 1 + 𝑦 = .
1+𝑦 𝑇

In financial markets either y or 𝐷𝑇 are given (= quoted).

The redemption yield / yield to maturity for a coupon bond is also a kind of average. This is
a fixed yield that precisely discounts all future payoffs from a coupon bond down to
its current price 𝑩𝒏 . For example, for an n-th bond that pays a coupon 𝐶𝑛 each year until it
is redeemed for 𝐹𝑉𝑛 in T years we obtain the annual yield to maturity by solving for 𝑦𝑛 in

𝑇
1 𝐹𝑉
𝐵𝑛 = 𝐶𝑛 × 𝑡
+ 𝑇
. (2)
1 + 𝑦𝑛 1 + 𝑦𝑛
𝑡=1

For an n-th bond that pays half a coupon 𝐶𝑛 2 twice a year for 2T half-years we obtain the
semi-annual yield to maturity by solving for 𝑦𝑛 in

2𝑇
𝐶𝑛 1 𝐹𝑉𝑛
𝐵𝑛 = × 𝑡
+ 2𝑇
. (3)
2 1 + 𝑦𝑛 2 1 + 𝑦𝑛 2
𝑡 =1

For the 3¾% Treasury gilt 2020 discussed in Lecture 1 as of 7 September 2015 we have:

10
1 100
𝐵𝑛 = 1.875 × 𝑡
+ 10
.
1 + 𝑦𝑛 2 1 + 𝑦𝑛 2
𝑡=1

Its price of £112.26 suggests its yield of 1.22%.

Equation (2) is in fact a T-degree polynomial equation with T roots. Since all of the cash
flows are non-negative, there is only one positive root and this is the yield to maturity.4
Equation (2) does not have a formal solution. Numerical techniques have to be applied.
Also there are online calculators which help calculate the yield to maturity (e.g.
https://www.investopedia.com/calculator/aoytm.aspx).

References

A good complementary material for Lecture 2 is given in:

Hull, J. Options, Futures, and Other Derivatives, 7th Ed. Prentice Hall. Chapter 4.

Campbell at al. The Econometrics of Financial Markets. Chapter 10, Section 10.1.1.

4
Project appraisal is a general case in a cash flow valuation model that allows for a negative cash flow over the life
of a project. A popular example is running a nuclear plant where a large outlay of money is required at the end of
the life of the project to dismantle the nuclear plant. In project appraisal we calculate the internal rate of return
like we calculate the yield to maturity in a coupon bond valuation. However, there could be several positive roots.
That makes finding the internal rate of return in project appraisal a little bit more challenging procedure than
finding the redemption yield for a coupon bond.