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Chapter 6 APPENDIX B - Pearsoncmg.com

Chapter 6 APPENDIX B - Pearsoncmg.com

Chapter 6 APPENDIX B -

178 Part 2 Interest Rates and Valuing Cash Flows Chapter 6 APPENDIX B The Yield Curve and the Law of One Price Thus far, we have focused on the relationship between the price of an individual bond and its yield to maturity. In this section, we explore the relationship between the prices and yields of different bonds. In Chapter 3, we saw how market forces keep the same asset from having two prices at the same time—we call this the Valuation Principle’s Law of One Price. Using the Law of One Price, we show that given the spot interest rates, which are the yields of default-free zero-coupon bonds, we can determine the price and yield of any other default-free bond. As a result, the yield curve provides sufficient information to evaluate all such bonds. Valuing a Coupon Bond with Zero-Coupon Prices We begin with the observation that it is possible to replicate the cash flows of a coupon bond using zero-coupon bonds. Therefore, we can use the Law of One Price to compute the price of a coupon bond from the prices of zero-coupon bonds. For example, we can replicate a three-year, $1000 bond that pays 10% annual coupons using three zerocoupon bonds as follows: 0 1 2 3 Coupon bond: $100 $100 $1100 1-year zero: 2-year zero: 3-year zero: $100 $100 $1100 Zero-coupon bond portfolio: $100 $100 $1100 We match each coupon payment to a zero-coupon bond with a face value equal to the coupon payment and a term equal to the time remaining to the coupon date. Similarly, we match the final bond payment (final coupon plus return of face value) in three years to a three-year zero-coupon bond with a corresponding face value of $1100. Because the coupon bond cash flows are identical to the cash flows of the portfolio of zero-coupon bonds, the Law of One Price states that the price of the portfolio of zero-coupon bonds must be the same as the price of the coupon bond. To illustrate, assume that current zero-coupon bond yields and prices are as shown in Table 6.7 (they are the same as in Example 6.1). We can calculate the cost of the zero-coupon bond portfolio that replicates the threeyear coupon bond as follows: Zero-Coupon Bond Face Value Required Cost 1 Year 100 96.62 2 Years 100 92.45 3 Years 1100 11 * 87.63 = 963.93 Total Cost: $1153.00

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