bond pricing with different spot rates/ discount rates

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

  1. 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

    Book's answer to problem

    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. 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).