A Further Look at Spot and Forward Rates

This chapter analyses the relationship between spot and forward rates and the yield curve. It describes the relationship between the price of a zero-coupon bond and spot and forward rates. A coupon bond may be regarded as a set of strips, with each coupon payment and the redemption payment on maturity being equivalent to a zero-coupon bond maturing on that date. The chapter presents an introduction to the bond price equation in continuous time. The market is assumed to be liquid so that bonds may be freely bought and sold. Prices of bonds are determined by the economy-wide supply and demand for the bonds at any time, so they are macroeconomic and not set by individual bond issuers or traders. The market assumes that the cash flow stream of assets such as bonds and equities is a function of the stated variables.