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Dear Tutor
The first article suggests that Interest is charged at the different Spot Yield Curve rates given for each year – hence the valuation $98.57
However the second article suggests that interest is charged (swapped) at the Spot Yield Curve rate for year 5 (6.3%) and applies to all years.
Based on the different cash flows the same bond would have different values
My question is: Which is the correct approach and Why?I am not quite sure what you mean because in both cases the discounting each year is at the spot yield curve for that year,
The second article is not suggesting that the interest is at 6.3% for all years – it is at 5.68%
Yes and thank you, I understand now that in both cases the discounting each year is at the spot yield curve for that year. However, it is the cash flows that are confusing me
First article; cash flows based on coupon rate and redeemable value (5 + 105)
Second article; cash flows, based on the compounded Spot Yield Curve, the bank is quoting Annual Forward Rates p.a. as follows:
Year1 3.5% + Year2 5.71% which is 4.6% each year = Yield Curve Year 2
Yr1 3.5%, Yr2 5.71% + Year3 7.02% which is 5.4% each year = Yield Curve Year3 and so on.
Cash flows based on the Annual Forward rates i.e. compounded Yield Curve results in fixed interest of 5.68% but if based on the actual Yield Curve it would be 4.58%.
If I’m correct in thinking that the Annual Forward rates = compounded Yield Curve then I guess is why compounded? or do I need to know?The difference is because in the first article the coupon rate is fixed.
The second article is completely different (and I think it was confusing for the writer to present them as a two part article as though they were completely connected) and we are trying to calculate the forward rates that the bank would quote ) and your last sentence is correct.
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