VRM 9. Pricing Conventions, Discounting, and Arbitrage

Learning Objectives

1) Define discount factor and use a discount function to compute present and future values.

2) Define the “law of one price”, explain it using an arbitrage argument, and describe how it can be applied to bond pricing.

3) Identify arbitrage opportunities for fixed income securities with certain cash flows.

4) Identify the components of a US Treasury coupon bond and compare the structure to Treasury STRIPS, including the difference between P-STRIPS and C-STRIPS.

5) Construct a replicating portfolio using multiple fixed income securities to match the cash flows of a given fixed-income security.

6) Differentiate between “clean” and “dirty” bond pricing and explain the implications of accrued interest with respect to bond pricing.

7) Describe the common day-count conventions used in bond pricing.