Derivatives

CHAPTER 9Bond Markets

Aims

• To explain spot rates (yields) and the ‘yield to maturity’ on a bond.
• To show that the ‘fair’ price of a coupon paying bond is determined by spot yields – otherwise risk-free arbitrage profits can be made by a strategy known as coupon stripping.
• To show how the yield to maturity is ‘derived’ from the market price of the bond.

There are a wide variety of different types of bonds. A conventional government bond usually pays to the holder a fixed amount of cash (‘the coupon’) every 6 months plus the maturity (redemption, par, or principal) value at the end of the bond's life. However, not all bonds have fixed coupons or fixed maturity dates. For example, some corporate bonds can be redeemed (or ‘called’) prior to their maturity date while other corporate bonds (i.e. convertible bonds) can be exchanged for common stock (equity) of the issuer, at some future date. So convertibles have a ‘mixture’ of payments in terms of coupons and then dividends if converted into equity.

Bonds are usually issued to obtain long term finance – the initial maturities are from 1 year to 30 years (with some being non-redeemable and known as perpetuities). They are issued by governments, and their agencies (e.g. Municipal Securities in the US and Local Authority Bonds in the UK) and by the corporate sector. They may be denominated in the home currency of the issuer or in a foreign currency (e.g. a UK corporate issuing dollar denominated bonds). A key difference between government ...