FIXED INCOME SECURITIES

PRICING & YIELD DISCOUNT FACTORS REPLICATING PORTFOLIO

1.Bond pricing is a Discounting Cash Flow exercise. CASE 1:Suppose bond to be replicated is Bond B
Bond Price=PV of cash flows &bonds which can be used for replication are
Case 1:FLAT TERM STRUCTURE Bond A&C(MATURITY OF ALL BONDS MATCH)
NOTE: Tuckman assumes semi-annual coupon. ∴P0=C0.5d(0.5)+C1d1+C1.5d(1.5)+….Cndn
Coupon Rates
Decide whether bond is trading cheap or rich? A B C
Mthd 1: Using yield on similar bonds/opp. 2.00% 4.00% 7.00%
Cost/Required Return,calculate the model price & Discounting Factors
then compare it with actual price. Discount factors can be calculated by
If actual price < model price, bond is trading cheap & Boot Strapping Method.
Distance=2 Distance=3
investor should go long. REVERSE
Mthd 2: : Using yield on similar bonds/opp.  Calc d0.5
Cost/Required Return & actual price, calculate the d0.5=Price/FV
 Then using value of d0.5,calculate d1 3 : 2
yield on the bond & then compare the yields. So, Price of B =0.6PA +0.4 PC
If calculated yield > yield on similar bonds,bond is Price= Coupon*d0.5+(Coupon +SV)*d1
trading cheap & investor should go long. & so on
After all discount factors are calculated, CASE 2:MATURITIES DO NOT MATCH
Calculate Bond Equivalent Yield(BEY)/Spot Rates Suppose there is a 2 yr bond with 10%
P 1/2n coupon to be replicated & bonds to be
P2 Positive Convexity =r0, n=[{1/dn} -1]*2
Or used for replication are:
USING CALCULATOR: Bond Coupon FV n
P0
1 FV A 7% 100 6mths
dn ± PV
P1
2n N B 12% 100 1yr
r CPT i/y *2
r2 r0 r1
Ignoring convexity, slope of the tangent C 5% 100 1.5yr
PRICE QUOTATIONS
=Duration= (P2-P1)/ 2P0∆y
D 6% 100 2yr
Case 2:NON FLAT TERM STRUCTURE
Implies Interest Rates depend on maturity. So,we have,
Bond Price=Coupon*Σd+Principal*dL T-NOTES & CORPORATE & 103% of FD=105.So;FD=101.94
Suppose,maturity of bond is 3yrs,the bond should be T-BONDS MUNICIPAL BONDS & Coupon=3% of 101.94=3.06
looked upon as a portfolio of 6 C Strips & 1 P Strip.
To prevent arbitrage,actual price of bond should be Price quoted as Price quoted as 3.06+102.5%of FC=5; FC=1.8927
equal to sum of parts. “32nds” “8ths” Coupon amt from C=2.5%of 1.8927=0.0473
Eg:- 102-17 Eg:-102-03+
Sit 1: Actual Price< Calculated Bond Price =102+17/32 =102+3.5/8 3.06+0.0473+106%of FB=5; FB=1.7856
Bond is underpriced =102.53% of FV =102.4375% of FV Coupon amt from B=6% of 1.7856=0.1071
Buy the bond from market & submit it to treasury for
stripping.The treasury issues 6 C strips & 1 P strip LAW OF ONE PRICE & ARBITRAGE ARGUMENT 3.06+0.0473+0.1071+103.5%of FA=5,
which we sell for sum of parts(Calculated Bond o Consider a coupon-bearing bond as a FA=1.7252
Price).Arbitrage profit is their difference. portfolio of zero-coupon securities-
specifically C strips & P strip. Thus ,on adding up cash flows of Bond
Sit 2: Actual Price> Calculated Bond Price o Law of One Price states that investors got A,B,C & D, we get exactly same cash flows
Bond is overpriced to be indifferent btw same cash flow in all years as that of the bond to be
Buy the strips from market at sum of parts coming from different bonds if timing & replicated.
(Calculated Bond Price),submit it to treasury for re- risk of the cash flow is same.
constitution.Treasury issues the reconstituted bond So,Price of a coupon-bearing bond=Sum Cost of the Replicating Portfolio
which we sell in market at Actual Price. Of Parts = (PV of A)% of FA+(PV of B)% of FB+
Arbitrage profit is their difference. o Arbitarge opportunity exists if Law Of One (PV of C)% of FC+ (PV of D)% of FD
Price does not hold good,as discussed
INFERENCE FROM THE TERM- earlier.Arbitrage forces will cause Market  If price matches with that of the
“ BOND IS UNDERPRICED” Price to move close to the Model Price. portfolio to be replicated-
Style 1: P0< IV0 NO ARBITRAGE.
Style 2:Yield on the bond> Yield on Similar Bonds OBSERVATIONS REGARDING STRIPS  If price of portfolio to be
Style 3:Spread on the bond> Spread on Similar Strips are less liquid than treasury.So, replicated < cost of replicating
Bonds. investors demand liquidity premium,i.e. portfolio, buy it & short sell
Yield spread is calculated as spead over Benchmark strip price could be lower than normal replicating portfolio.
Yield treasury price. Arbitrage profit=Difference
i.e. 10 yr Treasury Yield=9% Strips are heavily used for Asset-Liability  If price of portfolio to be
10 yr Corporate Yield=11.2% Management(ALM) replicated >cost of replicating
So, Yield Spread=2.2% C-Strips can be put with any bond to portfolio, short sell it & buy
reconstitute but P strips are identified with replicating portfolio.
* * *
 r1 =r1 +z,r2 =r2+z,r3 =r3+z specific bonds. Arbitrage profit=Difference
(where r1,r2,r3 are benchmark spot rates; Short Term C Strips are high in demand – Treasury
z=z spread) Securities Actual/Actual
They trade rich.
Day Count
 In case of option-embedded bonds,we use a Long Term C Strips are low in demand- Convention Corporate &
binomial model or MCS Approach to find They trade cheap. Municipal Bonds 30/360
out option-adjusted spread & not z-spread. Page 6