Par Rates from Spot Rates An important use of spot rates is determining par rates. A par rate is a yield-to-maturity that makes the present value of a bond’s cash flows equal to par (100% of face value). Par rates derived for hypothetical government bonds with different times-to-maturity are commonly used for term structure analysis because they control for…
Maturity Structure of Interest Rates Suppose that the yield-to-maturity is higher on one bond compared to another bond. There are several possible reasons for the difference, including credit risk, different currencies, liquidity, tax differences, and the periodicity assumption used in the yield calculation. This factor explaining the differences in yields is called the maturity structure of…
There are several important differences in yield measures quoted for money market instruments versus bonds: The pricing formula for money market instruments quoted on a discount rate basis. where The unique characteristics of a money market discount rate The pricing formula for money market instruments quoted on an add-on rate basis. where
Yield and Yield Spread Measures for Floating-Rate Instruments Floating-rate instruments, including floating-rate notes (FRNs or floaters) and most loans, are different from fixed-rate bonds. Rather than fixed coupon payments, they vary from period to period depending on the current level of a reference interest rate. For an FRN, PMT is a function of the MRR and the…
In fixed-income security analysis, it is important to understand why bond prices and yields-to-maturity change. To do this, it is useful to decompose a yield-to-maturity into a base rate or benchmark and an issuer-specific spread. The yield spread is the difference between the yield-to-maturity and the benchmark yield. Yield Spreads over the Benchmark Yield Curve The Z-spread over the…
Other Yield Measures and Conventions CYt = Annual coupont / Bond pricet The current yield is a crude measure of return because it focuses solely on interest income, ignoring the frequency of coupon payments, interest on interest (time value of money), and accrued interest. In addition to collecting and reinvesting coupon payments, the investor has a gain…
Investors analysing bonds with various cash flow and maturity profiles seek a standardised yield measure to compare across different choices. Yield measures are usually annualised in order to allow a direct comparison. For capital market securities maturing in more than one year, investors want an annualised and compounded yield-to-maturity. An annualised and compounded yield on a fixed-rate bond depends on the assumed number…
Matrix Pricing Process Unlike listed equity securities, most bonds are not actively traded, so there is often no current market price available to calculate yield-to-maturity. Matrix pricing also is used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate, or the difference in yield-to-maturity between the bond and…
Inverse Relationship For any time-value-of-money calculation, a higher discount rate results in a lower present value for any fixed future cash flow and a lower discount rate results in a higher present value. Therefore, bond yields-to-maturity and prices move in opposite directions. Coupon Effect The size of bond coupon cash flows affects how much a bond’s price…
Bond Pricing with a Market Discount Rate Bond pricing is an application of discounted cash flow analysis that depends on a bond’s cash flow features and the rate (or rates) used for discounting. The market discount rate is used in the time-value-of-money calculation to obtain the present value. The market discount rate is the rate…