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FV
FV
Time
Time
Yr 0
Yr 4 (Maturity Year)
CF CF CF CF
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Time
FV
CF CF CF CF
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Time
CF CF
Time
Yr 0 Yr 1 Yr 2
Discount the annuity
yields to present value.
1 1
PV = +
(1+ S1) (1+ S2) 2
1 1
= + 2
(1+ 0.5) (1+ 0.6)
PV (Annuity) = 1.8424
Calculate the Returns on Annuity for year 1 and 2 (R2) at the bond price of $1.8424
1 1
PV (Annuity) = + 2
(1+ R2) (1+ R2)
R2 = 5.65%
CF CF CF
Yr 0 Yr 1 Yr 2 Yr 3 Time
Discount the annuity
yields to present value.
1 1 1
PV = + 2 + 3
(1+ S1) (1+ S2) (1+ S3)
Substitute
S1= 5
S2 = 6
S3 = 7.5
PV of Annuity = 2.6473
1 1 1
PV (Annuity) = + 2 + 3
(1+ R3) (1+ R3) (1+ R3)
R3 = 6.524%
Spot Bond to Par Bond
For the first year, cash flows on both types of bonds are identical. Therefore, Par Yield for
1st Year is also 5%.
a) Determine the 2 year par yield (ie, YTM for a 2 year par bond) :
C C
Time
Yr 0 Yr 1 Yr 2
Px = 100 (Price of bond = 100, or the face value because it is a par bond)
Therefore, for par bond, coupon rate = YTM. Therefore, 2 year par yield = C = 5.97
b) Determine the 3-year par yield (ie, YTM for a 3 year par bond) :
Px = 100
100 = C/(1+S1) + C/(1+S2) 2 + (C+P)/(1+S3) 3
C = 7.36
Where
P = 100
S1 = 5%
S2 = 6%
S3 = 7.5%
Therefore, for par bond, coupon rate = YTM. Therefore, 3 year par yield = C = 7.36
Par Bond to Spot Bond
Figures indicated in RED are calculated in the below steps before imputing in. For the
first year, cash flows on both types of bonds are identical. Therefore, Spot Yield for 1st
Year is also 6%.
a) Determine the 2-year spot yield, ie, S2 from a 2-year par bond :
C C
Yr 0 Yr 1 Yr 2 Time
Px = 100 (Price of bond = 100, or the face value because it is a par bond)
Px = C/(1+S1) + (C+P)/(1+S2) 2
100 = 7/(1+0.06) + (7+100)/( 1+S2) 2
where
Px = 100,
C = 7 (2-year par bond’s YTM = 7% = coupon rate),
P = 100
S1 = 6%
Therefore, S2 = 7.035
a) Determine the 3-year spot yield, ie, S3 from a 3-year par bond :
C C C
Yr 0 Yr 1 Yr 2 Yr 3 Time
Px = 100 (Price of bond = 100, or the face value because it is a par bond)
Therefore, S3 = 9.22%