Chapter 4

Risk-free financial assets

Money market

The money market consists of risk free securities, typically bonds.

Definition 4.1
Bonds are financial assets promising the holder a sequence of guaranteed future pay-
ments.

Risk free means here that these payments will be made with certainty.

Definition 4.2
A zero-coupon bond is a bond involving just a single future payment.

The issuing institution of a zero-coupon bond promises to exchange the bond for a certain
amount of money F , the face value, on a given day T , the maturity date.
Effectively, the person who buys the bond is lending money to the bond issuer/writer.
Given an interest rate r and a maturity date, say one year, the present value of the bond
should be
V (0) = F (1 + r)−1 . (4.1)
In reality, the opposite happens: bonds are freely traded and their prices are driven by
market forces, whereas the interest rate is implied by the bond prices,
F
r= − 1. (4.2)
V (0)

This formula gives the implied annual compounding rate.

We will assume from now on that F = 1. Bonds can be sold at any time t prior to
maturity time T at some price, denoted by B (t, T ) . Note that B (T, T ) = F = 1. Again
these prices determine the implied interest rates. By applying formulas
 r −(T −t)m
V (t) = V (T ) 1 +
m
and V (t) = e−r(T −t) V (T ) with V (t) = B (t, T ) and V (T ) = 1, we get
 rm −m(T −t)
B (t, T ) = 1 + , (4.3)
1 m
CHAPTER 4. RISK-FREE FINANCIAL ASSETS 2

and
B (t, T ) = e−rc (T −t) . (4.4)

These different implied rates are equivalent, since the bond price does not depend on the
compounding method used.
In general, the implied interest rate may depend on the trading time as well as the
maturity date T. The dependence on T is called the term structure. Actually, the most
advanced models for interest rates model B (t, T ) as a two parameter stochastic process. In
this course we will adopt the simplifying assumption that the interest rate remains constant.

Example 4.1
An investor paid 95000 NOK for a bond with face value 100000 NOK maturing in
six months. When will the bond value reach 99000 NOK if the interest rate remains
constant?

Solution. For given F = 100000 NOK and V (0) = 95000 NOK we solve the equation
  126
6
100000 = 95000 · 1 + r ,
12
or
1, 0526315789 = (1 + 0.5r)0.5
for r to find the implied effective rate to be about 10.80 %. If this rate remains constant,
then the bond price will reach 99000 NOK at a time t such that

100000 = 99000(1 + r)(0.5−t) .

The solution is t ≈ 0.402 years, that is, about 0.402 · 365 ≈ 146.73 days. The bond price
will reach 99000 NOK on day 147.
Bonds promising a sequence of payments are called coupon bonds. These payments
consist of the face value due at maturity, and coupons paid regularly, typically annually,
semi-annually, or quarterly, the last coupon due at maturity. The assumption of constant
interest rates allows us to compute the price of a coupon bond by discounting all the future
payments.

Example 4.2
Consider a bond with face value F = 1000 NOK maturing in five years, T = 5, with
coupons of C = 100 NOK paid annually, the last one at maturity. This means a stream
of payments of 100, 100, 100, 100, 1100 NOK at the end of each consecutive year. Given
the continuous compounding rate r, say 12 %, we can find the price of the bond:

V (0) = 100e−r + 100e−2r + 100e−3r + 100e−4r + 1100e−5r =

= 100e−0.12 + 100e−0.24r + 100e−0.36 + 100e−0.48 + 1100e−0.6 ≈ 90.27.

The coupon can be expressed as a fraction of the face value. Assuming that coupons are
paid annually, we shall write C = iF , where i is called the coupon rate.
CHAPTER 4. RISK-FREE FINANCIAL ASSETS 3

Proposition 4.1
Whenever coupons are paid annually, the coupon rate is equal to the interest rate for
annual compounding if and only if the price of the bond is equal to its face value. In
this case we say that the bond sells at par.

Proof. To avoid cumbersome notation we restrict ourselves to an example. Suppose

that annual compounding with r = i applies, and consider a bond with face value F = 100
maturing in three years, T = 3. Then the price of the bond is
C C C +F rF rF F (1 + r)
+ 2
+ 3
= + 2
+ =
1 + r (1 + r) (1 + r) 1 + r (1 + r) (1 + r)3

rF rF F rF F (1 + r)
= + 2
+ 2
= + = F.
1 + r (1 + r) (1 + r) 1+r (1 + r)2
Conversely, note that
C C C +F
+ 2
+
1 + r (1 + r) (1 + r)3
is one-to-one as a function of r (in fact, a strictly decreasing function), so it assumes the
value F exactly once, and we know this happens for r = i.

• If a bond sells below the face value, it means that the implied interest rate is higher
than the coupon rate (since the price of a bond decreases when the interest rate goes
up). If the bond price is higher than the face value, it means that the interest rate is
lower than the coupon rate. This may be important information in real circumstances,
where the bond price is determined by the market and gives an indication of the level
of interest rates.

Price of the bond is the discounted value of cash flows

• Step 1: Determine cash flows from bond characteristics

• Step 2: Discount cash flows

n−1
X C C +F
Price = k
+
k=1
(1 + r) (1 + r)n
CHAPTER 4. RISK-FREE FINANCIAL ASSETS 4

Bank Account

Investment banks offer the possibility of investing in the money market by buying and
selling bonds on behalf of its customers. Actually, when you open a bank account attracting
some interest r, the bank trades in the money market to pay you that interest. Suppose you
open a deposit for T years and you set an initial amount A (0) . With A (0) the bank buys
A(0)
B(0,T )
bonds. The value of each bond if sold at time t < T yields

B (t, T ) = e−r(T −t) = ert e−rT = ert B (0, T ) .

As a result, the investment done by the bank gives

A (0)
A (t) = B (t, T ) = ert A (0) , t ≤ T, (4.5)
B (0, T )

which is also the value of your bank account. One can extend this procedure for all t by
buying new bonds with longer maturities.
The investment in a bond has a finite time horizon. It will be terminated with

A(T ) = A(0)erT

at the time T of maturity of the bond.

To extend the position in the money market beyond T one can reinvest the amount A(T )
into a bond newly issued at time T , maturing at T ′ > T .
Taking A(T )as the initial investment with T playing the role of the starting time, we
have
′ ′
A(t′ ) = A(T )e(t −T ) = A(0)ert for T < t′ < T ′ .
By repeating this argument, we readily arrive at the conclusion that an investment in the
money market can be prolonged for as long as required, the formula being valid for all t ≥ 0.

Example 4.3
Suppose that one dollar is invested in zero-coupon bonds maturing after one year. At
the end of each year the proceeds are reinvested in new bonds of the same kind. How
many bonds will be purchased at the end of year 9? Express the answer in terms of
the implied continuous compounding rate.

• At time t = 0 we buy
1
= er bonds;
B(0, 1)
• at time t = 1 we increase our holdings to
er
= e2r bonds;
B(1, 2)

• ...

• at time t = n we purchase
er
= e(n+1)r , one-year bonds.
B(n, n + 1)
CHAPTER 4. RISK-FREE FINANCIAL ASSETS 5

An alternative way to prolong an investment in the money market for as long as required
is to reinvest the face value of any bonds maturing at time T in other bonds issued at time
0, but maturing at a later time t > T .
Having invested A(0) initially to buy unit bonds maturing at time T , we will have the
sum of B(0,T
A(0)
)
at our disposal at time T .
At this time we chose a bond maturing at time t, its price at T being B(T, t). At time t
this investment will be worth

A(0) A(0)
= = A(0)ert .
B(0, T )B(T, t) B(0, t)

Finally, consider coupon bonds as a tool to manufacture an investment in the money

market. Suppose for simplicity that the first coupon C is due after one year. At time t = 0
we buy VA(0)
(0)
coupon bonds. After one year we cash the coupon and sell the bond for V (1),
receiving the total sum
C + V (1) = V (0)er .
Because the interest rate is constant, this sum of money is certain. In this way we have
effectively created a zero-coupon bond with face value V (0)er maturing at time t = 1. It
means that the scheme worked out above for zero-coupon bonds applies to coupon bonds.