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1、3BONDMATH—WITHOUTTHEMATHIt’stimetogetsomeofthehardstuffunderourbelts.Truthfully,though,it’snotsohard.Peoplehear“mathandtheyrecoil.Infact,atthebasicprofessionaluserlevel(asopposedtothe“quants”),whatmarketparticipantsrefertoasbondmathissimplystraightforwardarithmetic.BasicBondPricingLet’sworkwit
2、haplainvanilla,6%couponbond.Itpays$6forevery$100inprincipaleachyear(annualfrequency)untilitmaturesin?veyears.Thismakesita?ve-yearbond.We’llassumefornowthatthebondpresentsnoriskofdefault,suchasaU.S.governmentbond.1Thatis,theborrowerwillde?nitelypaywhateveritpromisesto.Butthisdoesnotmeanthattheb
3、ondisriskless.No,no!Notbyanystretchoftheimagination.Paycloseattention.Thegovernmentsells,or“issues,”thebondatpar.Parmeansthatinvestorshavepaidthesamepriceasthefacevalueofthebond.Onthebond’s“face”itsays$100,becausethat’stheprincipal—theamountthegovernmentwillreturntotheinvestorafter?veyears.You
4、lendthegov-ernment$100,itpromisestogiveyou$6everyyear(hence6%)plus$100atmaturity.Parisshortfor“parity.”Parity,inturn,suggestsasenseofevenness,orequivalence,orfairness,ifyoulike.Ifinvestorsarepayingpar,thismeansthat,giventheirperceptionofthestateof2324?FundamentalPrinciplesofBondStructure,Prici
5、ng,andInvestingtheworld(includingtheirviewofthefuture)andthesavingsattheirdisposal,theyaresatis?edtoreceivewhatthebondpromisestopay.Theywantnolessanddemandnomorethan6%forthemoneythey’relendingtothegovernmentatthispointintime.Considerthebond“dealers.”Youcanthinkofthesemarketpar-ticipantsasthest
6、orekeepers—thegovernmentmakestheproductandsellsittothestores,andinvestorsgotothestorestomaketheirpur-chases.Supposedealersstillhavesomeofthebondsleft.Veryrarelydobondsgetsoldoutimmediately,justlikedressesorbananas.Sometimelater,thegovernmentborrowsagain.Butthistimethingshavechangedintheworld,a
7、ndinvestorsnowrequire7%forlendingtothegovern-ment.So,theTreasuryissuesanew?ve-yearbondwithaninterestrateof7%,whichmakesthisbondpar.Buttheoldbondwiththe6%couponisstillaround,andsomeofthesebondsremainondealers’shelves.Thebondneedstogetsol
