Monday, January 23, 2017

Bond Basics: Part 6

In Part 5 of this series on bond basics, I derived the formula to calculate the price of a one-year bond in terms of its yield. I started by developing a formula to calculate something more familiar: the amount you end up with in a savings account after one year. In this part of the series I'll derive the formula to calculate the price of a bond with a term to maturity of more than one year, and again, I'll start with the more familiar concept of compound interest in a savings account.

Saturday, January 7, 2017

Bond Basics: Part 5

Much of the discussion in this series on bond basics has been about the inverse relationship between bond yield and bond price: when one goes up, the other goes down, and vice versa. My goal in this post is to help you begin to understand the mathematical formula that specifies bond price in terms of bond yield, since understanding this can facilitate a deeper understanding of bond fundamentals. We can start by considering something familiar: earning interest in a savings account. We can develop the simple formula that describes this, then with some elementary algebra, we can build on it to develop the formula that gives us bond price in terms of bond yield.

Wednesday, January 4, 2017

Bond Basics: Part 4

I had planned to start digging into the mathematical formula that relates bond price and bond yield in this post, but first I want to discuss one more example related to the topic discussed in Part 3 of this series. In that part, I explained that we can't make precise statements about the general relationship between interest rates and bond prices, because the yield (and price) of each bond changes differently depending on the bond market's assessment of the term risk and credit risk of that particular bond. Confusion about this is often exposed by questions about the impact of increases to the federal funds rate (FFR) on the prices of bond funds. So following is a brief discussion of this, and then in Part 5 I'll pick up on deriving the formula for bond pricing.