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
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