Hi

@Elizabeth_Babalola Sorry but there should be an additional set of parenthesis in the first formula. It should read:

=(100*0.75%/2*0.99925)+(100*0.75%/2*0.99648)+(

**(**100+100*0.75%/2

**)***0.99135)

... The final cash flow, that includes the principal, is (100 + 100 * 0.75%/2) and that is multiplied by the discount factor; without the parens, my formula adds the $100 to the PV, rather than the discounted $100*0.99135. Apologies, we will add it to revisions .... Thank you for your awesome attention to detail!

Re:

*"Also the 0.875 cash flow/coupon was omitted from the solution."*
Well these two (equivalent) formulas on page 7 are computing the model price of the 1.5 year bond referred to as the 3/4s (0.750% coupon) that expires on 11/30/2011. So it has three cash flows: in six months it pays a 0.750%/2 * $100.00 = $0.3750 coupon; in one year, another $0.3750 coupon, and finally, in 1.5 years $100.3750. Those three cash flows are discounted by multiplying by the respective discount factors: df(0.5) = 0.99925; df(1.0) = 0.99648; df(1.5) = 0.99135. The six-month bond, which we can refer to as "the 7/8s that matures in six months," and pays a 0.875%/2*100 = $0.43750 s.a. coupon,

*has no role in pricing the 1.5 year bond*. Now, in some applications, we might use the six-month bond to retrieve the six-month discount factor and then "bootstrap" that df(0.5) value to retrieve the 1.0 year discount factor, and finally use both df(0.5) and df(1.0) to infer the 1.5-year discount factor. Such an exercise would enforce, and in fact would be the very definition of presupposing, the Law of One Price because this law says there is only one discount function (set of discount factors) absent confounding factors (so basically, there is only one theoretical riskfree term structure/discount function).

But the point of this page per the label "

**Testing **the Law of One Price" is to

**assume **the previously derived discount function--i.e., df(0.5), df(1.0) and df(1.5)--already exists (i.e., "these bonds do not inform this discount function"). So we're basically assuming the discount function and using the same discount function to price all three bonds, which gets us the "model price" and then we compare that the the "market price" to determine which are "trading rich" or "trading cheap." Alternatively, we could forget the prior knowledge of the discount function, and use these three bonds to generate the implied set of discount factors. But then we wouldn't have a basis for determining "trade rich" versus "trade cheap." A bond trades rich/cheap when the observed (market) price

**varies **from the model price (i.e., discounted per the discount function ) whose discount function is informed by

*other *bonds. I hope that's interesting, maybe I even somehow addressed your second point, lol. Thanks,

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