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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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CHAPTER 2

Zero-Coupon Bonds

Bonds are in many ways easier to analyze than money market instruments. There are no antiquated “discount rates” that misrepresent an investor's rate of return. The yield to maturity on the bond will reflect the growth path over time for the investment under some reasonable assumptions. But the many cash flows received on a typical coupon-bearing bond cause a problem known as coupon reinvestment risk. The problem is that we have to estimate the rates at which we will be able to reinvest the coupons that we receive in the future, so the total return over the time to maturity is uncertain. We'll ignore that for now and focus in this chapter on a simple zero-coupon bond. There will be just two cash flows, one at purchase ...

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