Level 1 CFA® Exam:
Matrix Pricing
Matrix pricing is an estimation process that we use when we don’t know the market discount rate for a particular bond. We use matrix pricing to determine it. To get the proper discount rate, we use linear interpolation and yields to maturity of similar bonds.
Generally, we use matrix pricing in two cases:
- either when we want to value an illiquid bond, or
- when we want to find the required yield spread for a bond that is to be issued soon.
To grasp the idea of matrix pricing, we will solve two examples.
In the first example, we will see how to compute the bond price if the bond is not actively traded on the market, while in the second one we will find out how to calculate the required yield spread over the benchmark rate for a new bond that has not been issued yet.
The table provides us with the information about six bonds:
| Bond | Maturity (years) | YTM (%) |
|---|---|---|
| X | 3 | 4.150 |
| Y | 3 | 4.240 |
| Z | 3 | 4.380 |
| K | 6 | 5.155 |
| L | 6 | 5.255 |
| M | 6 | 5.360 |
An investor wants to value a 4-year Bond A with a par value equal to USD 100 that pays coupons annually. The coupon rate equals 5%. What is the price of the bond? Assume that the bonds given in the table and Bond A are characterized by similar credit risk.
(...)
In the table, you will find information about two Treasury bonds:
| Bond | Maturity (years) | YTM (%) |
|---|---|---|
| S | 1 | 1.150 |
| T | 5 | 1.230 |
ABC Company wants to issue a 5-year bond. The rate of return required by investors on a 2-year bond issued by ABC company is 2.5%. What is the required yield spread over the benchmark rate on the 5-year bond that the company is going to issue?
Assume that the yield spread is the same for all maturities.
(...)
- Matrix pricing is an estimation process that we use when we don’t know the market discount rate for a particular bond.
- We use matrix pricing in two cases: 1) when we want to value an illiquid bond, or 2) when we want to find the required yield spread for a bond that is to be issued soon.