ABSTRACT
Let us consider a very simple bond. Today (call it time zero) the borrower receives $X. In exchange, she promises to repay $X(1 + c) at time T. We call $X the principal, c the coupon rate, and T the term of the bond. What is a fair value for the coupon rate c? (We note, in a nod to Chapter 11, that the coupon rate c is computed in a simple rate convention.)
It is plain to see that the coupon rate must compensate investors for two things. It must directly compensate the investor for the “time value of money,” which is the property that money now, since it can be put to work, is worth more than money later. It must also, and indirectly, compensate the investor for the chance that the loan is repaid only incompletely.
