The Classical Approach

This chapter explores the classical approach to pricing fixed income securities. The classical approach to coupon bond pricing uses only the notion of an internal rate of return and simple calculus to generate the traditional risk management parameters— yields, duration, modified duration, and convexity. The classical approach to fixed income analysis concentrates on studying coupon bonds. A callable coupon bond is a coupon bond that can be repurchased by the issuer, at predetermined times and prices, prior to its maturity. A coupon-bearing bond is a loan for a fixed amount of dollars, called the principal or face value. The loan extends for a fixed time period, called the life or maturity of the bond. Historical term structure evolutions are inconsistent with parallel shifts in the yield curve, making modified duration hedging imprecise.