Chapter 2

Bond Value and Return

Value
The value of a bond is the present value of its
future cash flow (CF):
M
M
2
2
M
1 t
1
1
t
t
B
0
) R 1 (
CF
) R 1 (
CF
) R 1 (
CF
) R 1 (
CF
V
+
+ +
+
+
+
=
+
=

=
maturity M
. return required R
coupon or / and principal ; t at flow cash CF
: where
t
=
=
=
Value
Generic bond: Assume the bond makes fixed
coupon payments each year and principal at
maturity.
M
M
1 t
t
B
0
) R 1 (
F
) R 1 (
C
V
+
+
+
=

=
principal F
coupon C
: where
=
=
Value
M
M
B
0
M
a
B
0
M
1 t
M t
B
0
M
M
1 t
t
B
0
) R 1 (
F
R
) R 1 /( 1 1
C V
) R 1 (
F
)] M , R ( PVIF [ C V
) R 1 (
F
) R 1 (
1
C V
) R 1 (
F
) R 1 (
C
V
+
+
(

+
=
+
+ =
+
+
+
=
+
+
+
=

=
=
Value
Example: 10-year, 9% annual coupon bond (9% of par), with F
= $1,000 and required return of 10% would have a value of
$938.55:
55 . 938 $
) 10 . 1 (
1000 $
10 .
) 10 . 1 /( 1 1
90 $ V
) R 1 (
F
R
) R 1 /( 1 1
C V
) 10 . 1 (
1000 $
) 10 . 1 (
90 $
V
) R 1 (
F
) R 1 (
C
V
10
10
B
0
M
M
B
0
10
10
1 t
t
B
0
M
M
1 t
t
B
0
= +
(

=
+
+
(

+
=
+ =
+
+
+
=

=
=
Bond Price Relations
Bond Relation 1: Relation between coupon rate,
required rate (discount rate), bond value (price), and
face value (principal):
bond premium F V R C If
bond par F V R C If
bond discount F V R C If
F / C rate coupon C Let
R
R
R
R
> >
= =
< <
= =
Bond Price Relations (2)
Bond Relation 2: Inverse relation between bond
price (value) and rate of return.
0
R
V
V R If
V R If
<
A
A
| +
+ |
Bond Price Relations
Bond Relation 2: Price-Yield Curve depicts the inverse
relation between V and R. The Price-Yield curve for
the 10-year, 9% coupon bond:
B
V
R
$938.55
$1000
9% 10%
-
-
Bond Price Relations
Bond Relation 3: The greater a bonds maturity,
the greater its price sensitivity to interest rate
changes. Symbolically:
c
A
A
= c
Greater M Greater
R %
V %
Let
Bond Price Relations
Bond Relation 3: Illustration
% 55 . 6 V % % 10 R %
1000 $ V % 9 R
55 . 938 $ V % 10 R
bond coupon % 9 Year 10
B
0
B
0
= A = A
= =
= =

% 9 . 0 V % % 10 R %
1000 $ V % 9 R
91 . 990 $ V % 10 R
bond coupon % 9 Year 1
B
0
B
0
= A = A
= =
= =

Bond Price Relations

Bond Relation 4: The smaller a bonds coupon
rate, the greater its price sensitivity to interest
rate changes. Symbolically:
c
A
A
= c
Greater C Lower
R %
V %
Let
R
Semi-Annual Coupon Payments
If a bond pays coupons semiannually, the
coupon is quoted on an annual basis, and the
discount rate is quoted on a simple annual
basis, then the value of the bond is found by:
Doubling the number of periods (measured as
years).
Taking half of the annual coupons.
Taking half of the simple annual rate.
Semi-Annual Coupon Payments
Example: 10-year, 9% coupon bond, with F=$1,000, required
return of 10%, and coupon payments made semiannually.
years in maturity M : Note
69 . 937 $
) 05 . 1 (
1000 $
05 .
) 05 . 1 /( 1 1
45 $ V
)) 2 / R ( 1 (
F
2 / R
)) 2 / R ( 1 /( 1 1
2 / C V
) 05 . 1 (
1000 $
) 05 . 1 (
45 $
V
)) 2 / R ( 1 (
F
)) 2 / R ( 1 (
2 / C
V
20
20
B
0
M 2 A A
M 2 A
A B
0
20
20
1 t
t
B
0
M 2 A
M 2
1 t
t A
A
B
0
=
= +
(

=
+
+
(

+
=
+ =
+
+
+
=

=
=
n-Coupon Payments per year
The rule for valuing semiannual bonds is easily
extended to valuing bonds paying interest even
more frequently.

For example, to determine the value of a bond
paying interest four times a year, we would
quadruple the number of annual periods and
quarter the annual coupon payment and discount
rate.
n-Coupon Payments per year
In general, if we let n be equal to the number of payments per year
(i.e., the compounding per year), M be equal to the maturity in
years, and, as before, R
A
be the discount rate quoted on an annual
basis, then we can express the general formula for valuing a bond
as follows:

year per payments of number n
years in maturity M : Note
)) n / R ( 1 (
F
n / R
)) n / R ( 1 /( 1 1
n / C V
)) n / R ( 1 (
F
)) n / R ( 1 (
n / C
V
nM A A
nM A
A B
0
nM A
nM
1 t
t A
A
B
0
=
=
+
+
(

+
=
+
+
+
=

=
Compounding Frequency
The 10% annual rate in the previous example is a simple
annual rate: It is the rate with one annualized
compounding. With one annualized compounding, we
earn 10% every year and $100 would grow to equal
$110 after one years:
$100(1.10) = $110.
If the simple annual rate were expressed with semi-
annual compounding, then we would earn 5% every six
months with the interest being reinvested; in this case,
$100 would grow to equal $110.25 after one year:

$100(1.05)
2
= $110.25.
Compounding Frequency
If the rate were expressed with monthly compounding,
then we would earn .8333% (10%/12) every month with
the interest being reinvested; in this case, $100 would
grow to equal $110.47 after one year:

$100(1.008333)
12
= $110.47.
If we extend the compounding frequency to daily, then
we would earn .0274% (10%/365) daily, and with the
reinvestment of interest, a $100 investment would grow
to equal $110.52 after one year:
$100(1+(.10/365))
365
= $110.52.
Compounding Frequency
Note that the rate of 10% is the simple annual rate.

The rate that includes the reinvestment of interest (or
compounding) is known as the effective rate.

Effective Rate = (1+(R
A
/n))
n
1

Compound Frequency
When the compounding becomes large, such as daily compounding,
then we are approaching continuous compounding. For cases in
which there is continuous compounding, the future value (FV) for
an investment of A dollars M-years from now becomes:
where e is the natural exponent (equal to the irrational number
2.71828).
Thus, if the 10% simple rate were expressed with continuous
compounding, then $100 (A) would grow to equal $110.52 after
one year:
$100e
(.10)(1)
= $110.52.
RM
e A FV =
Compounding Frequency
The present value (A) of a future receipt (FV) with
continuous compounding is
If R = .10, a security paying $100 two years from now
would currently be worth $81.87, given continuous
compounding:
PV = $100 e
-(.10)(2)
= $81.87.
Similarly, a security paying $100 each year for two years
would be currently worth $172.36:
RM
RM
FVe
e
FV
PV A

= = =
36 . 172 $ e 100 $ e 100 $ e 100 $ PV
) 2 )( 10 (. ) 1 )( 10 (.
2
1 t
) t )( 10 (.
= + = =

=

Compounding Frequency
If we assume continuous compounding and a
discount rate of 10%, then the value of a 10-year,
9% bond would be $908.82:
82 . 908 $ e 1000 $ e 90 $ V
e F e C V
) 10 )( 10 (.
10
1 t
) t )( 10 (. b
0
M
1 t
RM Rt A b
0
= + =
+ =

Valuation of Pure Discount Bond

with Maturity of Less than One Year
) days 365 ( year a of
proportion a as maturity M : where
) R 1 (
F
V
M A
B
0
=
+
=
96
) 0853 . 1 (
100
V
100 F , 365 / 182 M , 0853 . R
: Example
365 / 182
B
0
A
= =
= = =
Day Count Convention
The choice of time measurement used in valuing bonds is known
as the day count convention.
The day count convention is defined as the way in which the ratio
of the number of days to maturity (or days between dates) to the
number of days in the reference period (e.g., year) is calculated.
A day count convention of actual days to maturity to actual days in the
year (actual/actual)
A day count convention of 30-day months to maturity to a 360 days in the
year (30/360)
For short-term U.S. Treasury bills and other money market
securities, the convention is to use actual number of days based
on a 360-day year.
Valuing a Bond at Non-Coupon Date
When you buy a bond between coupon dates,
you pay the seller a full price.
The full price (or dirty price) consist of:
1. Clean Price: Price of the bond without the accrued
interest
2. Accrued interest
) Coupon (
dates coupon between days Total
date coupon last from Days
Interest Accrued =
Interest Accrued price Clean price Full + =
price Dirty
Valuing a Bond at Non-Coupon Date
Method for solving for the full price:
1. Move to the next coupon date and determine
the value of the bond at that date.
2. Add coupon to the value of bond.
3. Discount the bond value plus coupon back to
the current date.
Valuing a Bond at Non-Coupon Date
Example: You buy a 10% annual coupon bond with a face value of
$1,000, original maturity of 7 years, and current maturity of 6.5. If
R = 10%, your full price would be $1048.81:
1 5
4
3 2 6 .5 7 0

=
= + =
6
1 t
6 t
B
6
1000 $
) 10 . 1 (
1000 $
) 10 . 1 (
100 $
V
81 . 1048 $
) 10 . 1 (
100 $ 1000 $
V
5 .
B
5 . 6
=
+
=
100 $ 1000 $ C V
B
6
+ = +
81 . 1048 $ V
B
5 . 6
=
purchase of Time
Valuing a Bond at Non-Coupon Date
Example: 10% annual coupon bond with a face value of
$1,000, original maturity of 7 years, and current
maturity of 6.5.

=
= + =
6
1 t
6 t
B
6
1000 $
) 10 . 1 (
1000 $
) 10 . 1 (
100 $
V
81 . 1048 $
) 10 . 1 (
100 $ 1000 $
V
5 .
B
5 . 6
=
+
=
price at next
coupon date
full price
50 $ ) 100 ($ 5 . =
Accrued Interest
81 . 998 $ 50 $ 81 . 1048 $ = Clean price
}
}
}
}
Price Quotes
Many traders quote bond prices as a
percentage of their par value.
For example, if a bond is selling at par, it
would be quoted at 100 (100% of par).
A bond with a face value of $10,000 and
quoted at 80-1/8 would be selling at (.80125)
($10,000) = $8,012.50.
Fractions
When a bond's price is quoted as a
percentage of its par, the quote is usually
expressed in points and fractions of a
point, with each point equal to $1.
Thus, a quote of 97 points means that the
bond is selling for $97 for each $100 of
par.
Fractions
The fractions of points differ among bonds.
Fractions are either in thirds, eighths, quarters, halves, or
64ths.
On a $100 basis, a 1/2 point is $0.50 and a 1/32 point is
$0.03125.
A price quote of 97-4/32 (97-4) is 97.125 for a bond with a
100 face value.
Bonds expressed in 64ths usually are denoted in the
financial pages with a plus sign (+); for example, 100.2+
would indicate a price of 100 2/64.
Basis Points
Fractions on yields are often quoted in terms
of basis points (BP).
A BP is equal to 1/100 of a percentage point.
6.5% may be quoted as 6% plus 50 BP or 650
BP
An increase in yield from 6.5% to 6.55% would
represent an increase of 5 BP
Bid and Ask Prices
The bid price is the price the dealer is willing
to pay for the bond.
The ask price is the price the dealer is
willing to sell the bond.
Bid and Ask Yields
Some dealers provide quotes in terms of bid and
ask yields instead of prices.
The bid yield is the return expressed as a percent
of the par value that the dealer wants if she buys
the bill; this yield is often annualized.
The ask yield is the rate that the dealer is offering
to sell bills.
Bid and Ask Yields
For Treasury Bills and some other securities, bid
and ask yields are quoted as a discount yield.
The discount yield, R
D
, is the annualized return
specified as a proportion of the bill's par value (F):
Maturity to Days
360
F
P F
R Yield Discount Annual
0
D

= =
Bid and Ask Yields
Given the dealer's discount yield, the bid or ask
price can be obtained by solving the yield equation
for the bonds price, P
0
. Doing this yields:
| | ) 360 / Maturity to Days ( R 1 ( F P
D 0
=
Rate of Return: Common Measures
Current yield of a bond is the ratio of its annual
coupon to its closing price.
Coupon rate, C
R
, is the contractual rate the issuer
agrees to pay each period. It is expressed as a
proportion of the annual coupon payment to the
bond's face value:
F
Coupon Annual
C
R
=
Rate of Return: Common Measures
The term interest rate is sometimes referred to the
price a borrower pays a lender for a loan. Unlike
other prices, this price of credit is expressed as the
ratio of the cost or fee for borrowing and the
amount borrowed.
This price is typically expressed as an annual
percentage of the loan (even if the loan is for less
than one year).
Today, financial economists often refer to the
yield to maturity on a bond as the interest rate.
Yield to Maturity
In Finance, the most widely acceptable rate of return measure for
a bond is the yield to maturity, YTM.
YTM is the rate that equates the price of the bond, P
0
B
, to the
PV of the bonds CF; it is similar to the internal rate of return,
IRR.
In our illustrative example, if the price of the 10-year, 9% annual
coupon bond were priced at $938.55, then its YTM would be
10%.
10 . YTM
) YTM 1 (
1000 $
) YTM 1 (
90 $
55 . 938 $
) YTM 1 (
F
) YTM 1 (
C
P
10
10
1 t
t
M
M
1 t
t
B
0
=
+
+
+
=
+
+
+
=

=
=
Yield to Maturity
The YTM is the effective rate of return. As a
rate measure, it includes:
Return from coupons
Capital gains or losses
Reinvestment of coupons at the calculated YTM
Bond Equivalent Yield
The rate on bonds are often quoted as a simple
annual rate (with no compounding).
For bonds with semi-annual coupon payments,
this rate can be found by solving for the YTM
on a bond using 6-month CFs and then
multiplying that rate by 2. This rate is also
known as the bond-equivalent yield.
Bond Equivalent Yield
Example: 10-year, 9% bond with semi-annual
payments, and trading at 937.69 would have a YTM
for a 6-month period of 5% and a bond-equivalent
yield of 10%.
Note: The effective rate is 10.25%.
Bonds with different payment frequencies often
have their rates expressed in terms of their bond-
equivalent yield so that their rates can be compared
to each other on a common basis.
Average Rate to Maturity (ARTM)
Unless the CFs are constant, there is no algebraic solution to
finding the YTM. The YTM is found through an iterative process
(trial and error).
The YTM can be estimated using the ARTM (also referred to as
the yield approximation formula):
The ARTM for the 9%, 10year bond trading at $938.55 is
0.0992:
2 / ) P F (
] M / ) P F [( C
ARTM
b
0
B
o
+
+
=
0992 .
2 / ) 55 . 938 $ 1000 ($
] 10 / ) 55 . 938 $ 1000 [($ 90 $
ARTM =
+
+
=
YTM on Pure Discount Bond
Algebraic solution to the YTM on a pure discount bond
(PDB):
1
P
F
YTM
1
P
F
YTM
P
F
) YTM 1 (
) YTM 1 (
F
P
: ebra lg A
M / 1
B
0
M
B
0
B
0
M
M
B
0

=
=
= +
+
=
YTM on Pure Discount Bond
Examples:
0772 . 1
800 $
1000 $
YTM
years 3 M , 1000 $ F , 800 $ P : Example
3 / 1
B
0
=
(

=
= = =
0853 . 1
96 $
100 $
YTM
365 / 182 M
, 365 / Actual Convention Count Day
, days 182 aturity M , 100 $ F , 96 $ P : Example
182 / 365
B
0
=
(

=
=
=
= = =
YTM on Pure Discount Bond with
Continuous Compounding
Algebraic solution to the YTM on a pure discount bond with continuous
compounding:
t
] P / F ln[
R
P
F
ln Rt
P
F
ln ) e ln(
P
F
e
F e P
: ebra lg A
b
0
b
0
b
0
Rt
b
0
Rt
Rt B
0
=
(

=
(

=
=
=
081868 .
365 / 182
] 96 / 100 ln[
YTM
365 / 182 M
, 365 / Actual Convention Count Day
, days 182 aturity M , 100 $ F , 96 $ P : Example
B
0
= =
=
=
= = =
Definition:
Logarithmic Return: The rate of
return expressed as the natural
log of the ratio of its end-of-
the-period value to it current
value
Yield to Call
Many bonds have a call feature that allows the issuer to buy back
the bond at a specific price known as the call price, CP.
Given a bond with a call option, the yield to call, YTC, is the rate
obtained by assuming the bond is called on the first call date, CD.

Like the YTM, the YTC is found by solving for the rate that
equates the present value of the CFs to the market price.
M
CD
1 t
t
t
B
0
) YTC 1 (
CP
) YTC 1 (
CF
P
+
+
+
=

=
Yield to Call
A 10-year, 9% coupon bond, first callable in 5
years at a call price of $1100, paying interest
semiannually and trading at $937.69 would have a
YTC of 12.2115%:
122115 . ) 0610575 )(. 2 ( YTC Annualized Simple
0610575 . YTC
) y 1 (
1100 $
) y 1 (
45 $
69 . 937 $
10
1 t
10 t
= =
=
+
+
+
=

=
Yield to Worst
Many investors calculate the YTC for each
possible call date, as well as the YTM. They then
select the lowest of the yields as their yield return
measure. The lowest yield is sometimes referred
to as the yield to worst.
Bond Portfolio Yield
The yield for a portfolio of bonds is found by solving the
rate that will make the present value of the portfolio's cash
flow equal to the market value of the portfolio.
For example, a portfolio consisting of a two-year, 5%
annual coupon bond priced at par (100) and a three-year,
10% annual coupon bond priced at 107.87 to yield 7%
(YTM) would generate a three-year cash flow of $15, $115,
and $110 and would have a portfolio market value of
$207.87. The rate that equates this portfolio's cash flow to
its portfolio value is 6.2%:
062 . y
) y 1 (
110 $
) y 1 (
115 $
) y 1 (
15 $
87 . 207 $
3 2 1
=
+ +
+
+
=
Bond Portfolio Yield
Note: The bond portfolio yield is not the weighted
average of the YTM of the bonds comprising the
portfolio. In this example, the weighted average
(R
p
) is 6.04%:
Thus, the yield for a portfolio of bonds is not
simply the average of the YTMs of the bonds
making up the portfolio.
0604 . ) 07 (.
87 . 207 $
87 . 107 $
) 05 (.
87 . 207 $
100 $
R
) YTM ( w ) YTM ( w R
p
2 2 1 1 P
=
(

+
(

=
+ =
Spot Rates and the
Equilibrium Bond Price
Spot Rate is the rate on a PDB.
Relation: The equilibrium price of a bond is the price
obtained by discounting the bonds CFs by spot rates.
If this price does not hold, then an arbitrage opportunity
exist by buying the bond and stripping it into a series of
PDBs and selling them, or by buying PDBs, bundling
them, and then selling the bundled bond.
Spot Rates and the
Equilibrium Bond Price
Example:
Let S
t
= spot rate on a bond with a maturity of t
Assume: S
1
= 7%, S
2
= 8%, and S
3
= 9%
The equilibrium price, P
0
*
, of a 3-year, 8%
coupon bond with F = 100 is 97.73:
73 . 97 $
) 09 . 1 (
108 $
) 08 . 1 (
8 $
) 07 . 1 (
8 $
P
) S 1 (
F C
) S 1 (
C
) S 1 (
C
P
3 2 1
*
0
3
3
3
2
2
2
1
1
1
*
0
= + + =
+
+
+
+
+
+
=
Spot Rates and the
Equilibrium Bond Price
Suppose the market prices the 3-year, 8% bond at
95.
Arbitrage
Buy the bond for 95
Form three stripped PDBs and sell them:
1-Year PDB with F = 8: Selling Price = 8/1.07 = 7.4766
2-Year PDB with F = 8: Selling Price = 8/(1.08)
2
= 6.8587
3-Year PDB with F = 108: Selling Price = 108(1.09)
3
=
83.3958
Sale of strip bonds = 97.73
Risk-free profit = 97.73-95 = 2.73
Spot Rates and the
Equilibrium Bond Price
Given this risk-free opportunity, arbitrageurs
would implement this strategy of buying and
stripping the bond until the price of the
coupon bond was bid up to equal its
equilibrium price of $97.73. At that price, the
arbitrage would disappear.
Spot Rates and the
Equilibrium Bond Price
Suppose the market prices the 3-year, 8% bond at
100.
Arbitrage
Buy three PDBs (assume F = 100 on each):
8% of 1-Year PDB: Cost = (.08)(100/1.07) = 7.4766
8% of 2-Year PDB: Cost = (.08)(100/(1.08)
2)
= 6.8587
108% of 3-Year PDB: Cost = (1.08)(100/(109)
3)
= 83.3958
Total Cost of PDBs = 97.73
Bundle the bonds and sell them as a 3-year, 8%
coupon bond for 100
Risk-free profit = 100-97.73 = 2.27
Spot Rates and the
Equilibrium Bond Price
Given this risk-free opportunity, arbitrageurs
would implement this strategy of buying
PDBs, bundling the bonds, and selling 3-year
coupon bonds until the price of the 3-year
coupon bond was bid down to equal its
equilibrium price of $97.73. At that price, the
arbitrage would disappear.
Estimating Spot Rates -- Bootstrapping
One problem in valuing bonds with spot rates
or in creating stripped securities is that there
are not enough longer-term pure discount
bonds available to determine the spot rates on
higher maturities. As a result, long-term spot
rates have to be estimated.
One estimating approach that can be used is a
sequential process commonly referred to as
bootstrapping.
Estimating Spot Rates -- Bootstrapping:
Bootstrapping Approach
The approach requires having at least one
pure discount bond. Given this bond's rate, a
coupon bond with the next highest maturity is
used to obtain an implied spot rate; then
another coupon bond with the next highest
maturity is used to find the next spot rates,
and so on.
Estimating Spot Rates -- Bootstrapping
100 100 9% 3 Years
100 100 8% 2 Years
100 100 7% 1 Year
Price Principal Annual
Coupon
Maturity
0912 . 1
88 . 83
109
S
) S 1 (
109
88 . 83
) S 1 (
109
) 08042 . 1 (
9
07 . 1
9
100
: 0912 . S
3 / 1
3
3
3
3
3
2
3
=
(

=
+
=
+
+ + =
=
Estimating Spot Rates -- Bootstrapping
07 . 1
100
107
S
) S 1 (
107
100
: 07 . S
1
1
1
1
=
(

=
+
=
=
08042 . 1
52 . 95
108
S
) S 1 (
108
52 . 95
) S 1 (
108
07 . 1
8
100
: 08042 . S
2 / 1
2
2
2
2
2
2
=
(

=
+
=
+
+ =
=
Annual Realized Return: ARR
The ARR (also call the total return) is the rate
obtained by assuming all CFs are reinvested to the
investors horizon date (HD) -- date the investor
liquidates the bond investment.
1
P
Value HD
ARR
) ARR 1 (
Value HD
P
HD / 1
B
0
HD
B
0

=
+
=
B
HD HD
2 HD
2
1 HD
1
P CF ) R 1 ( CF ) R 1 ( CF Value HD + + + + + + =

Annual Realized Return
Example 1: You buy 4-year, 10% annual coupon bond at par (F =
1000) and your HD = 3 years. Assuming you can reinvest CFs at
10%, your ARR would be 10%:
10 . 1
1000
1331
1
P
Value HD
ARR
3 / 1
HD / 1
B
0
3
=
(

=
(

=
1331
1100 1000 100
110 ) 10 . 1 ( 100 100
121 ) 10 . 1 ( 100 100
HD 3 2 1 0
1
2
= +
=
=
=
1000
) 10 . 1 (
100 1000
P
1
B
3
=
+
=
Assumption
Assumption
Assumption
Annual Realized Return
Note: If the rates at which coupons can be reinvested are
the same (as assumed in this example), then the coupon
values at the horizon date would be equal to the period
coupon times the future value of an annuity of (FVIF
a
):
331 $
10 .
1 ) 10 . 1 (
100 $ Value
R
1 ) R 1 (
C Value
FVIF C Value
) R 1 ( C Value
) R 1 ( C Value
: HD at Value Coupon
3
HD
a
1 HD
0 t
t
1 HD
0 t
t
=
(

=
(

+
=
=

+ =

+ =

=
Annual Realized Return
Note: The ARR is equal to the calculated
YTM if the CFs can be reinvested at the
calculated YTM and the bond can be sold at
the calculated YTM.
ARR illustrates that the YTM captures the
return from coupons, capital gains, and the
reinvestment of CFs at the calculated YTM.
Since rates do change over time, the ARR will
not equal the calculated YTM.
Annual Realized Return: ARR
Market Risk: The uncertainty that the realized return will deviate
from the expected return because of changes in interest rates.
Suppose in our example that shortly after you purchased the bond,
rates on all maturities increased from 10% to 12% and remained
there until you sold the bond at your HD. In this case, your ARR
would be 9.68%:
. returns coupon greater the than value
absolute in greater is loss capital the , case this In
. loss capital but , return coupon Greater R : Note
0968 . 1
1000
58 . 1319
ARR
58 . 1319
12 . 1
100 1000
100 ) 12 . 1 ( 100 ) 12 . 1 ( 100 Value HD
3 / 1
3
2
|
=
(

=
=
+
+ + + =
Annual Realized Return Semiannual Return
Example 2: You buy 4-year, 10% coupon bond paying interest semiannually
at par (F = 1000) and your HD = 3 years. Assuming you can reinvest CFs at
5% semiannually, your semiannual realized return would be 5%, your simple
annual rate would be 10%, and your effective annual rate would be 10.25%:
10 . 340 , 1 $ 000 , 1 $ 10 . 340 $ Value HD
000 , 1 $
) 05 . 1 (
1000 $
05 .
) ) 05 . 1 /( 1 ( 1
50 $
) 05 . 1 (
1000 $
) 05 . 1 (
50 $
ice Pr
10 . 340 $
05 .
1 ) 05 . 1 (
50 $ ) 05 . 1 ( 50 $ Value Coupon
6
6
6
6
1 t
t
6
1 6
0 t
t
= + =
= +
(

= +

=
=
(

=
=

=
1025 . 1 ) 05 . 1 ( Rate Annual Effective
10 . 1
000 , 1 $
10 . 340 , 1 $
2 ARR Simple
05 . 1
000 , 1 $
10 . 340 , 1 $
turn Re alized Re Semiannual
2
6 / 1
6 / 1
= =
=
(
(

=
=
(

=
Geometric Mean
Geometric Mean: YTM expressed as an average
(geometric average) of todays rate and implied
forward rates, f
MT
. The implied forward rate, f
MT
, is
a future rate implied by todays rates.
1 )] f 1 ( ) f 1 )( f 1 )( f 1 )( YTM 1 [( YTM
M / 1
1 M , 1 13 12 11 1 M
+ + + + + =

Geometric Mean
Recall the example of the 3-year PDB: bond
trading at $800, principal of $1000 at
maturity, and YTM of 7.72%.
The PDB can be viewed as an $800
investment that will grow at an annual rate of
7.72% over three years to equal $1000:
1000 $ ) 0772 . 1 ( 800 $
3
=
Geometric Mean
There are other ways in which an $800 investment can
grow to equal $1000 at the end of three years.
Example: If rates on current 1-year bonds are at R
Mt

= R
10
= 10%, rates on 1-year bonds one year from
now are expected to be at R
11
= 8%, and rates on 1-
year bonds two years from now are expected to be at
R
12
= 5.219%, then an $800 investment will grow
over three years to equal $1000.
1000 $ ) 05219 . 1 )( 08 . 1 )( 10 . 1 ( 800 $ =
Geometric Mean
YTM of 7.72% can therefore be viewed as the geometric
average of 10%, 8%, and 5.219%:
)] 05219 . 1 )( 08 . 1 )( 10 . 1 [(
800 $
1000 $
) 0772 . 1 (
)] R 1 ( ) R 1 )( R 1 )( R 1 )( YTM 1 [(
P
F
) YTM 1 (
)] R 1 ( ) R 1 )( R 1 )( R 1 )( YTM 1 [( P F ) YTM 1 ( P
3
1 M , 1 13 12 11 1
B
0
M
M
1 M , 1 13 12 11 1
B
0
M
M
B
0
= =
+ + + + + = = +
+ + + + + = = +

| | 0772 . 1 ) 05219 . 1 )( 08 . 1 )( 10 . 1 ( YTM

3 / 1
3
= =
Geometric Mean
Implied Forward Rate: Future rate that is implied by todays
rates and attainable by a locking-in strategy.
Suppose the current YTM on a 2-year PDB is 9% and the
current YTM on a 1-year PDB is 10%. Using the geometric
mean, the implied forward rate on a 1-year bond, one year from
now would be 8%.
| |
08 . 1
) 10 . 1 (
) 09 . 1 (
f
1
) YTM 1 (
) YTM 1 (
f
1 ) f 1 )( YTM 1 ( YTM
2
11
1
2
2
11
2 / 1
11 1 2
= =

+
+
=
+ + =
Geometric Mean
Locking-in Strategy:
(1) Execute a shortsale by borrowing the oneyear bond and
selling it at its market price of $909.09 = $1,000/1.10 (or
borrow $909.09 at 10%).
(2) With twoyear bonds trading at $841.68 = $1,000/(1.09)
2
,
buy $909.09/$841.68 = 1.08 issues of the two year bond.
(3) One year later, cover the short sale by paying the holder of the
one-year bond his principal of $1,000 (or repay loan).
(4) Two years later receive the principal on the maturing
twoyear bond issues of (1.08)($1,000) = $1,080.
Geometric Mean
With this lockingin strategy the investor does not make a cash
investment until the end of the first year when he covers the
short sale; in the present, the investor simply initiates the
strategy.
Thus, the investment of $1,000 is made at the end of the first
year. In turn, the return on the investment is the principal
payment of $1,080 on the 1.08 holdings of the twoyear bonds
that comes one year after the investment is made.
The rate of return on this oneyear investment is 8%
(($1,080$1,000)/$1,000).
Hence, by using a lockingin strategy, an 8% rate of return on a
oneyear investment to be made one year in the future is
attained, with the rate being the same rate obtained by solving
algebraically for f
11
.
Geometric Mean
Given the concept of implied forward rates, the
geometric mean can be formally defined as the
geometric average of the current oneyear spot rate
and the implied forward rates:
1 )] f 1 ( ) f 1 )( f 1 )( f 1 )( YTM 1 [( YTM
M / 1
1 M , 1 13 12 11 1 M
+ + + + + =

Geometric Mean
Note: the geometric mean is not limited to oneyear rates. That
is, just as 7.72% can be thought of as an average of three
oneyear rates of 10%, 8% and 5.219%, an implied rate on a
2year bond purchased at the end of one year, f
Mt
= f
21
, can
be thought of as the average of oneyear implied rates
purchased one and two years, respectively, from now.
Accordingly, the geometric mean could incorporate an implied
twoyear bond by substituting (1+f
21
)
2
for (1+f
11
)(1+f
12
).
Similarly, to incorporate a 2year bond purchased in the
present period and yielding YTM
2
, one would substitute
(1+YTM
2
)
2
for (1+YTM
1
) (1+f
11
).
Geometric Mean
1 )] f 1 ( ) YTM 1 [( YTM
1 ] ) f 1 )( YTM 1 [( YTM
1 )] f 1 )( f 1 )( YTM 1 [( YTM
3 / 1
12
2
2 3
3 / 1 2
21 1 3
3 / 1
12 11 1 3
+ + =
+ + =
+ + + =
Geometric Mean
For bonds with maturities of less than one year, the same
general formula for the geometric mean applies. For example,
the annualized YTM on a pure discount bond maturing in 182
days (YTM
182
) is equal to the geometric average of a current
91-day bond's annualized rate (YTM
91
) and the annualized
implied forward rate on a 91-day investment made 91 days
from the present, f
91,91
:
| | 1 ) f 1 ( ) YTM 1 ( YTM
182 / 365
365 / 91
91 , 91
365 / 91
91 182
+ + =
Geometric Mean
One of the practical uses of the geometric mean is in comparing
investments in bonds with different maturities.
For example, if the present interest rate structure for pure discount
bonds were such that two-year bonds were providing an average
annual rate of 9% and one-year bonds were at 10%, then the
implied forward rate on a one-year bond, one year from now
would be 8%. With these rates, an investor could equate an
investment in the two-year bond at 9% as being equivalent to an
investment in a one-year bond today at 10% and a one-year
investment to be made one year later yielding 8%.
If an investor with an HD = 2 years knew with certainty that one-year
bonds at the end of one year would be trading at a rate greater than 8%
(implied forward rate), then he would prefer an investment in the series of
one-year bonds over the two-year bond;.
If he expected a rate less than 8%, then he would prefer the two-year bond.
Geometric Mean
| |
| | 1 08 . 1 )( 10 . 1 ( 09 .
1 ) f 1 )( YTM 1 ( YTM
: bond year 2 Buy : 1 e Alternativ
2 / 1
2 / 1
11 1 2
=
+ + =

| | 1 r ( E 1 )( 10 . 1 ( YTM
: ) r ( E at later year one
bond year 1 and % 10 at today year 1
: bonds year 1 of series Buy : 2 e Alternativ
2 / 1
11 series : 2
11
+ =


Geometric Mean
In a a world of certainty (or risk-neutral world), the investor
would:
prefer the two-year bond over the series if E(r
11
) < f
11
prefer the series over the 2-year bond if E(r
11
) > f
11

be indifferent if E(r
11
) = f
11
.
| |
| | 1 ) r ( E 1 )( 10 . 1 ( YTM
09 . 1 ) 08 . 1 )( 10 . 1 ( YTM
2 / 1
11 series : 2
2 / 1
2
+ =
= =
.07
.08
.09
085 .
.09
.095
Geometric Mean
In general, whether the investor decides to invest in
an M-year bond or a series of one-year bonds, or
some combination with the equivalent maturity,
depends on what the investor expects rates will be
in the future relative to the forward rates implied by
today's interest rate structure.
Websites
There are a number of financial calculators available on the
web. Many of these require a fee but do provide a free
sample for viewing. See www.bondcalc.com and www.
derivativesmodels.com. A free calculator that can be used
to calculate values and rates is provided by the U.S.
Treasury: www.publicdebt.treas.gov/sav/savcalc.htm.
Yields on Treasuries and other bonds can be found at a
number of sites. For a sample, see: www.bloomberg.com
and http://bonds.yahoo.com.