ECO349H5 Chap.2 Bond Pricing and Market Microstructure
Bond Pricing and Market Microstructure
Cash flows before yields
A bond is a dated sequence of promised payments. Record face value, coupon amount, payment frequency and maturity before selecting an equation. A zero-coupon claim has one maturity payment. A coupon bond pays along the way and returns principal at maturity.
Each amount must be discounted from its own date; treating the whole schedule as one terminal payment produces the wrong exposure to interest rates.
Keep the clock internally consistent
The discount rate and the exponent must use the same period. Semiannual coupons require semiannual periods and a consistently converted rate.
A timeline is the fastest audit because it reveals a missing coupon, a duplicated face value or a mismatched horizon.
After computing present value, perform a direction check: with promised cash flows fixed, a higher discount yield should lower price, and a longer wait should increase the effect of a given yield change.
Yield to maturity is the constant rate that equates the observed price with the present value of promised payments. It is not the coupon rate and not necessarily the investor’s realized return.
The coupon rate is written into the contract. Current yield uses annual coupon divided by current price. Realized return can differ because of default, reinvestment conditions or sale before maturity. State which object a question requests before solving.
Move from valuation to issuance
In a primary auction, investors compete for newly issued claims.
Each bidder’s participation condition gives a break-even price or coupon based on its valuation. The winning terms can also depend on the auction rule and the next-best bid, so the most patient investor need not surrender all of its valuation surplus.
Show private break-even values first, apply the allocation and payment rule second, and identify who keeps the remaining surplus last.
The issuer and investor view the same schedule from opposite sides. Cash promised by the issuer is an asset to the holder and a financing cost to the borrower. If their discount rates differ, their present values differ without any inconsistency.
Be explicit about whose objective is being maximized. Do not subtract principal twice when moving from the security payoff to the issuer’s net financing position.
Market structure changes execution
After issuance, a bond can trade on an exchange or through bilateral over-the-counter contact.
Search, bargaining, dealer inventories and visibility determine how readily traders locate counterparties and compare quotes. These features can generate price dispersion among otherwise similar claims. A bid is what a dealer offers to pay; an ask is what the dealer requests from a buyer. The buyer pays the ask and the seller receives the bid.
Liquidity and credit are distinct explanations for a yield spread.
A claim can be safe at maturity yet costly to sell quickly, while a liquid claim can still carry repayment risk. Compare issuer, maturity, coupon, tax treatment and embedded options before assigning a residual spread to liquidity.
Newly issued and actively traded claims may differ from older claims because of resale convenience, not because their legal promise changed.
Build complete answers
Start with the payment timeline, write the present-value equation, solve and report the unit. For an auction, add the relevant participation constraints and market rule. For a trading question, identify the venue and the side of the quote.
End with one economic sentence: explain whether a price difference came from time value, default exposure, liquidity or bargaining. This sequence prevents institutional vocabulary from replacing the valuation mechanics it is meant to explain.
What this chapter covers
- 01
Present value
- 02
Coupon bonds
- 03
Yield to maturity
- 04
Bond auctions
- 05
OTC liquidity
Worked example · free
Price a claim from its yield
- 2Place the single maturity payment on a three-year timeline and write its discount expression.
- 2Evaluate present value and interpret why it is below the promised payment.
Key terms
- Coupon
- A Coupon is a contractual payment made before or at bond maturity.
- Bid-Ask Spread
- A Bid-Ask Spread is the difference between executable buying and selling quotes.
Bond Pricing and Market Microstructure FAQ
Why do bond prices fall when yields rise?
With promised cash flows fixed, a higher discount rate reduces their present value. The inverse relation is mechanical inside the valuation formula, while the economic reason for the yield change may involve expectations, risk or liquidity.
How do auctions differ from OTC trade?
An auction gathers competing bids under an allocation rule, whereas OTC trade is negotiated bilaterally or through dealers. Visibility, sequencing and access change price dispersion, volume and the distribution of surplus.
What should be checked before comparing two yields?
Hold issuer, maturity, coupon structure, tax treatment and embedded options as comparable as possible. Otherwise a spread can combine default, duration, liquidity and contractual differences rather than identifying one clean premium.
Exam move
Draw every payment, solve one break-even coupon, then explain how the execution venue can move price around the valuation benchmark.
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