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# bond pricing with different spot rates/ discount rates

Discussion in 'Economics' started by Vibnad1991, Jan 12, 2012.

Hi, I am an economics student at LSE and i have difficulty with the fundamental concept of bond pring usinf discounted cash flows.
Here is a simple example illustrated in my textbook:
two year bond
5% coupon
1000 par/face value
1year spot rate 8%
2 year spot rate %

My interpretation of how to price this bond:

PV= 50/1.08 + 1050/(1.08)(1.1)
= 930.1346

PV= 50/1.08 + 1050/1.1^2
= 914.06

The fundamental difference between my answer and the book answer is the way the second year cash flow has been discounted. I feel it should be discounted by 1.1 x 1.08, whereas they have discounted it by 1.1^2, which indicates that the potential rate of retun in the first year is 10%, when in fact the expected rate of return in the first yearis actually 8%. Please any help as to why to i may have misunderstood this topic would be much aprecciated

2. ### H2O

The 2yr rate is the expected rate of return for a 2 year investment, not for the 2nd year.

Hope this helps

3. ### Martinghoul

Yep, like the previous poster said, the 2nd year coupon should be discounted at the 2y spot rate. What you're trying to do is use the 1y spot + 1y 1y fwd, which is backwards (because the 1y 1y fwd rate is calculated from the 1y spot and the 2y spot).

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