2. Bond Prices - Department of Mathematics（2。）.pdfVIP

2. Bond Prices A bond is a security which offers semi-annual* interest payments, at a rate r , for a fixed period of time, followed by a return of capital. Suppose you purchase a $1,000 utility bond, freshly issued, which offers 16% interest per annum, payable semi-annually, and matures in 15 years. What you have in effect purchased is an annuity of 15 × 2 = 30 semi-annual interest payments of $80 each ( 8% of $1,000), plus a return of your $1,000 15 years later. On the face of it, you are receiving $3,400 in return for your original $1,000. But the interest payments span a period of 15 years, so let us calculate the present value of all interest payments, and the present value of the $1,000 returned in 15 years’ time. The present value will depend on the current interest rate; suppose it is i per semi-annual period. Then the present value of the above bond is given by the present value of all 30 interest payments, which is 80a30 |i , plus the present value of the $1,000 received in 15 years, which is 1, 000(1 + i)−30 . Hence the present value of the bond is −30 P = 1000(1 + i) + 80a30 |i . Note that if i = .08 , P = 99.38 + 900.62 = 1000 ; but if i .08 , P is greater than $1,000; and if i .08 , P is less that $1,000. In general we can show that for a bond with face value V , with n outstanding interest payments at rate r each, (1) P = V (1 + i)−n + rV an |i , where i is the current interest rate per semi-annual period. In formula (1), P is referred to as the price of the bond, r the coupon rate, and i the yield rate. (Coupon and yield rates are often quoted