The Bond Market
Bonds are an important asset traded around the world everyday on many different
trading platforms. You can buy and sell both corporate and government bonds
through brokers who have connections to large trading exchanges (some of which
are electronic). Americans can now open an account and buy US government
bonds online through TreasuryDirect@.
This is the interface
for buying
government bonds
with TreasuryDirect@
New Bonds
Issued
Primary Market
Secondary Market
(e.g. NYSE)
Buyer
later
Banks maintain large trading
floors to help individuals and firms
trade in bonds.
Massive UBS trading floor in
Stamford, CT – 1400 seats with 2000
computers and 5000 monitors
Outside of the building housing the Bank
of America Trading floor in Charlotte NC
The NYSE offers trading in many types
of bonds.
But...what are bonds and how are they
priced?
A Bond is merely a formal means of borrowing money.
In the past, bonds were paper and they were held by custodial banks, not
engaged in commercial banking. These custodial banks continue to exist
today, but paper bonds are being made largely irrelevant by digitization of
bonds.
A central securities depository (CSD) is a specialist financial organization holding securities
so that ownership can be easily transferred through a book entry rather than the transfer of
physical certificates. This allows brokers and financial companies to hold their securities at
one location where they can be available for clearing and settlement. This is usually done
electronically making it much faster and easier than was traditionally the case where
physical certificates had to be exchanged after a trade had been completed.
Three Things cannot change on a bond --
Face
Value
Maturity
Date
Coupons
paid
semiannually
Each six months you can “clip off a coupon and get $25 in
interest – fixed income
After one year...our 20 year bond (with 40 coupons)
becomes a 19 year bond (with 38 coupons)
After two years...our 20 year bond (with 40 coupons originally)
becomes an 18 year bond (with 36 coupons)... and so on
Finally, after 19 years...our 20 year bond (with 40 coupons
originally) becomes an 1 year bond (with only 2 coupons). This
one year bond must compete in the secondary market with all
one year bonds...even ones that were issued for only one year.
The yield to maturity for all one year bonds will
determine the price of this bond, as well ... it has
become a one year bond, since there is only one year
remaining before it matures.
Remember...it is 2033 now ...with just one more year to
maturity !!!
IT’S A ONE YEAR BOND.
The price of our 20 year bond can be computed as follows
$25
$25
PB 


1
2
(1  r ') (1  r ')
$1025

40
(1  r ')
The yield to maturity here is the 6-month yield since the
coupons are paid every six months ... to get the annual yield
to maturity we use the formula
r  (1  r ')  1
2
This means hat we can substitute the formula into our bond price
equation to get the relation between PB and r ... anyway, its all
the same
$25
$25
PB 


1/2
2/2
(1  r )
(1  r )
$1025

40/2
(1  r )
If it was a 20 year bond, but paid $4 coupons every month, we would
have
$4
$4
PB 


1/12
2/12
(1  r )
(1  r )
$1004

240/12
(1  r )
Here is the Excel command that returns the yield as given in the
Wall Street Journal’s quotation page
Fidelity has its own little yield/price online calculator which
rounds the yield up to 0.02%....very imprecise
Supply: Borrowers
Demand: Lenders
Remember – Bond prices and interest rates must
move inversely to each other. Always.
I discussed some cases for the bond market in class. This was to
help you gain some intuition about bonds. What did we discover?
(1) If unforeseen inflation occurs, it can be bad for bonds.
(2) If there is a recession, usually long term government bonds do
well. You can make money if you have good foresight.
(3) The US is often a safe haven for foreign investors that are having
trouble in their own countries. This is good for the long term US
bond market.
(4) Big government deficits can be bad for bonds. Large deficits
means more bonds are issued....driving down prices in the bond
market and raising interest rates.
(5) Interest rates have five important parts to them; namely
R  r  rl  r  rm  rK
Please see class notes
See You in Class