The core reading says as "These can be monitored as well as yield differences. Ideally, a switch under consideration will look attractive, in relation to both yield and price histories. A practical problem in using price ratios is that they do not allow for the fact that the two bonds may have different coupons; they will have different prices but will both be redeemed at 100. So the ratio of the two prices will display a trend. This history of price ratios may be adjusted by this trend to produce what are often known as ‘stabilized’ price ratios." Yield Models "Rather than compare a bond’s yield with a redemption yield curve it can be compared with one of the alternatives such as a yield surface or par yield curve." Could you please elaborate this with an example and illustrate the above points ?
Hi Pulit, You asked a similar question on price ratios before, and which was answered here: https://www.acted.co.uk/forums/inde...nd-switching-identifying-cheap-or-dear.18270/ By playing with discounted cashflow valuations of bonds with differing coupons we can see how the price ratios of fairly-priced bonds might be expected to follow a trend, rather than be stable. For example ... Assume there are two otherwise similar gilts, which both have just 6-months to run before being redeemed at 100, but which pay coupons in arrears of 6 and 4 each half-year respectively. That means the final payment from the bonds will be 106 and 104 respectively. Let's assume that an appropriate half-year discount rate is 1%. Then a DCF valuation 6-months prior to redemption would be 106/1.01=104.95 and 104/1.01=102.97 respectively. So, if the discount rate is constant, then the (dirty) price ratio is expected to move from 104.95/102.97 to 106/104 over a period of 6-months. Changes in the price ratio over time in line with this trend should not automatically be interpreted as an indication that the prices are anomalous. However, a change in price ratio away from this expected trend might be an indication that a price anomaly exists. With regard yield surfaces and the like, please refer to: https://www.acted.co.uk/forums/index.php?threads/yield-surface.17320/. Best wishes David
