Bonds are typically priced “relative” Generally: Lower quality is priced relative to higher quality Lower liquidity is priced relative to higher liquidity Relative to what? –Individual bond –Collection of bonds (like an index) “Spread” pricing: –Yield of Treasury = 4.68% –Yield of Corporate = 5.68% –Spread of Corporate = 100bp Spread is measure of credit risk –Base interest rate + spread –Base interest rate + risk premium –Spread = risk premium

Pricing Bonds off a “Yield Curve” Collection of liquid, high quality bonds (like an index) Price using “spread” off matching benchmark bond Match on maturity - the bond’s “remaining term” to “closest” benchmark “Yield Curve” constituent criteria: –Type of Issuer –Issuer’s perceived credit worthiness –Term of maturity of the instrument –Others: optionality, taxability, expected liquidity… The benchmark we will use is: –Current (most recently issued) “Treasuries” –“On-the-run” vs “Off-the-run” Example: –“Trading 30 over the 10 year” –Means: “yield of the quoted bond is 30 basis points more yield than the treasury bond yield which has a maturity of 10 years” “Treasuries” (no credit risk, highest quality, highest liquidity - benchmark to the world) What is the “normal” shape of the “yield curve”? How do the treasury yields come to be? –Fed funds rate, discount rate, auction results

Deliverables for Nov 9 Build a yield curve class 4 bonds in curve: 2, 5,10,30 year maturities Load in new yield curve data file –Special version of existing “data.txt” –Bonds with ticker “T” Load new bond data file which will include a new field: –Spread : “30bp” and tag “SPREAD” or “YIELD” Price and run risk for the book using the curve Our scenarios will be different yield curves: –Parallel up/down, tilts (flatter, steeper)