CHAPTER 3 Bond Pricing, Spot, and Forward Rates

In this chapter, we present basic concepts of yield and interest rates, and then follow this with a discussion of yield-curve analysis and the term structure of interest rates.

BASIC CONCEPTS

We are familiar with two types of fixed-income security, zero-coupon bonds, also known as discount bonds or strips, and coupon bonds. A zero-coupon bond makes a single payment on its maturity date, while a coupon bond makes regular interest payments at regular dates up to and including its maturity date. A coupon bond may be regarded as a set of strips, with each coupon payment and the redemption payment on maturity being equivalent to a zero-coupon bond maturing on that date. This is not a purely academic concept—witness events before the advent of the formal market in U.S. Treasury strips, when a number of investment banks had traded the cash flows of Treasury securities as separate zero-coupon securities.1 The literature we review in this section is set in a market of default-free bonds, whether they are zero-coupon bonds or coupon bonds. The market is assumed to be liquid, so that bonds may be freely bought and sold. Prices of bonds are determined by the economy-wide supply and demand for the bonds at any time, so they are macroeconomic and not set by individual bond issuers or traders.

Zero-Coupon Bonds

A zero-coupon bond is the simplest fixed-income security. It is an issue of debt, the issuer promising to pay the face value of ...

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