CFA® Level I – Fixed Income

Introduction to Fixed-Income Valuation

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 Contents and Introduction
1. Introduction

2. Bond Prices and the Time Value of Money

3. Prices and Yields: Conventions for Quotes and Calculations

4. The Maturity Structure of Interest Rates

5. Yield Spreads

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 2. Bond Prices and the Time Value of Money

1. Bond Pricing with a Market Discount Rate

2. Yield-to-Maturity

3. Relationship between Bond Price and Bond Characteristics

4. Pricing Bonds with Spot Rates

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2.1 Bond Pricing with a Market Discount Rate
Bond price = present value of all future cash flows at the market discount rate
Market discount rate: rate of return required by investors given the risk of the bond
Market discount rate = required yield = required rate of return

Example: The coupon rate on a bond is 4% and the payment is made once a year. The
time-to-maturity is five years and the market discount rate is 6%. What is the bond
price per 100 of par value?

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 Premium, Par and Discount Bonds
Another five-year bond has a coupon rate of 8% paid annually. If the market discount rate is again
6%, the price of the bond is…

What if the coupon rate is 6%?


Coupon rate < market discount rate Discount bond

Coupon rate > market discount rate Premium bond

What if the coupon rate is 2%? Coupon rate = market discount rate Par bond

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Example 1

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 2.2 Yield-to-Maturity
The yield-to-maturity is the internal rate of return on the cash flows—the uniform interest rate such
that when the future cash flows are discounted at that rate, the sum of the present values equals
the price of the bond. It is the implied market discount rate.

Three assumptions:
1. Investor holds till maturity
2. Issuer makes all payments
3. Investor reinvests at YTM rate

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2.3 Relationships between the Bond Price and
Bond Characteristics

Inverse Effect

Convexity Effect

Coupon Effect

Maturity Effect

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 Inverse Effect and Convexity Effect
Bond price is inversely related to the market discount rate.

For the same coupon rate and time-to-maturity, the percentage price change is
greater (in absolute value, meaning without regard to the sign of the change)
when the market discount rate goes down than when it goes up.

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 Coupon Effect and Maturity Effect
For the same time-to-maturity, a lower-coupon bond has a greater percentage
price change than a higher-coupon bond when their market discount rates change
by the same amount.

Generally, for the same coupon rate, a longer-term bond has a greater percentage
price change than a shorter-term bond when their market discount rates change
by the same amount.

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Example 3

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Constant Yield Trajectory

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 2.4 Pricing Bonds with Spot Rates
Spot rates are yields-to-maturity on zero-coupon bonds maturing at the date of each cash flow.
Bond price (or value) determined using the spot rates is sometimes referred to as the bond’s “no-
arbitrage value.” If a bond’s price differs from its no-arbitrage value, an arbitrage opportunity exists
in the absence of transaction costs.

The one-year spot rate is 2%, the two-year spot rate is 3%, and the three-year spot rate is 4%. What is the price
of a three-year bond that makes a 5% annual coupon payment?

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Example 4

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 3. Prices and Yields: Conventions for
Quotes and Calculations
1. Flat Price, Accrued Interest and the Full Price

2. Matrix Pricing

3. Yield Measures for Fixed-Rate Bonds

4. Yield Measures for Floating-Rate Notes

5. Yield Measures for Money Market Instruments

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 3.1 Flat Price, Accrued Interest, and the Full Price
Flat
When a bond is between coupon payment dates, its price has two parts: the flat price (PV ) and the
Full
accrued interest (AI). The sum of the parts is the full price (PV ), which also is called the invoice or
“dirty” price. The flat price, which is the full price minus the accrued interest, is also called the
quoted or “clean” price.

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Example 5

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 3.2 Matrix Pricing
Matrix pricing: If the market price for bond is not available, estimate the market discount rate and
price based on the quoted or flat prices of more frequently traded comparable bonds. These
comparable bonds have similar times-to-maturity, coupon rates, and credit quality.

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Example 6

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 More on Matrix Pricing
Matrix pricing is used when underwriting new bonds to get an estimate of
the required yield spread over the benchmark rate

Term structure of credit spreads

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 3.3 Yield Measures for Fixed-Rate Bonds
Consider a 5-year zero coupon bond priced at 80 per 100 par value. What is
stated annual rate for periodicity = 4, periodicity = 2 and periodicity = 1?

Effective annual yield

Semi-annual bond equivalent yield

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Example 7

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 More on Yield Measures
• Street convention

• True yield

• Government equivalent yield

• Current yield

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Example 8

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 More on Yield Measures
• Yield to first call
• Yield to second call
• Yield to worst
• Option adjusted price
• Option adjusted yield

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 3.4 Yield Measures for Floating-Rate Notes
• FRN
• Quoted Margin
• Required Margin
• Discount Margin
• Change in Reference Rate
• Change in Credit Risk

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“Simplified” FRN Pricing Model
Simplifying assumptions:
1. PV is for a rate reset date
2. 30/360 day-count convention
3. same reference rate used
for all periods

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Example 9

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 3.5 Yield Measures for Money Market Instruments
Money market instruments are short-term debt securities. They range in time-to- maturity from
overnight sale and repurchase agreements (repos) to one-year bank certificates of deposit. Money
market instruments also include commercial paper, government issues of less than one year,
bankers’ acceptances, and time deposits based on such indices as Libor and Euribor.

Bond Market Yields Money Market Yields

• annualized and compounded • annualized and stated on a simple interest basis

• calculated using standard time-value- • non-standard calculation; discount rates or
of-money analysis add-on rates
• stated for a common periodicity for all • Instruments with different times-to- maturity
times-to-maturity have different periodicities for the annual rate

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 Discount Basis Yield
Suppose that a 91-day U.S. Treasury bill (T-bill) with a face value of USD10 million is quoted at a
discount rate of 2.25% for an assumed 360-day year. Enter FV = 10,000,000, Days = 91, Year = 360,
and DR = 0.0225. What is the price?

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 Add On Rate
Suppose that a Canadian pension fund buys a 180-day banker’s acceptance (BA) with a quoted add-on
rate of 4.38% for a 365-day year. If the initial principal amount is CAD10 million, what is the
redemption amount due at maturity?

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 Comparing Discount Basis with Add On Yield
Suppose that an investor is comparing two money market instruments: (A) 90-day commercial paper
quoted at a discount rate of 5.76% for a 360-day year and (B) 90- day bank time deposit quoted at an
add-on rate of 5.90% for a 365-day year. Which offers the higher expected rate of return assuming
that the credit risks are the same?

When a discount rate is converted to an add-on rate, the converted rate is a bond equivalent yield or
“investment yield”.

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Example 10

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 Periodicity of the Annual Rate
The third difference between yield measures in the money market and the bond market is the
periodicity of the annual rate. Because bond yields-to-maturity are computed using interest rate
compounding, there is a well-defined periodicity. For instance, bond yields-to-maturity for
semiannual compounding are annualized for a periodicity of two. Money market rates are computed
using simple interest without compounding. In the money market, the periodicity is the number of
days in the year divided by the number of days to maturity. Therefore, money market rates for
different times-to-maturity have different periodicities.

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 4. The Maturity Structure of Interest Rates
The spot rate curve plots different maturities on the x-axis and
corresponding spot rates on the y-axis. Spot rates are yields-to-
maturity (or return earned) on zero coupon bonds maturing at
the date of each cash flow, if the bond is held to maturity. The
spot rate curve is also called the zero or strip curve.

The yield curve plots yields of bonds on the y-axis versus

maturity on the x-axis. The main difference between a yield curve
and a spot rate curve is that the yield curve considers the coupon
payments as well. The assumption in a spot rate curve is that
there are no coupon payments.

The par curve plots yield-to-maturity for different maturities but

the bonds are assumed to be priced at par. They also have the
same currency, credit risk, tax status, liquidity, periodicity etc.

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 Forward Curve and Spot Curve
A forward rate is the interest rate on money borrowed in the future. Forward rates are
generally written in this format: “2y1y”. This is the rate on a 1 year loan starting 2 years
from today.

Implied forward rates are calculated from spot rates. Say the 3-year spot rate is 10% and the
2-year spot rate is 9%. What is the implied 2y1y?

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Example 11

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 Application of Forward Rates
Implied spot rates can be calculated as geometric averages of forward rates.

Bonds can then be priced using implied spot rates.

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 5. Yield Spreads

Benchmark spread: yield spread over a specific

benchmark such as Libor or Treasury bond yield.

G-spread: yield spread over an actual or

interpolated government bond

I-spread: yield spread over the standards swap

rate (same currency, same tenor)

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 Z-Spread
A Z-spread (zero-volatility spread) is based on the entire benchmark spot curve. It is the constant
spread that is added to each spot rate such that the present value of the cash flows matches the
price of the bond.

Example 12

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 OAS
An option-adjusted spread (OAS) on a callable bond is the Z-spread minus the theoretical value of
the embedded call option.

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