Chapter 4
Interest Rates
Options, Futures, and Other Derivatives 8th Edition,
1
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•
•
•
•
Repo rates
LIBOR rates
Treasury rates
Fed funds rate
Types of Rates
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2
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Treasury Rates
• Rates on instruments issued by a government in its
own currency.
• Rates that an investor earns from Treasury Bills or
Treasury Bonds
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• These are the instruments used by a government to
borrow in its own currency
• It is assumed that there is no chance that government
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will default on an obligation denominated in its own
currency.
• Basically these rates are considered Risk-Free Rate.
3
LIBOR and LIBID
• LIBOR is the rate of interest at which a bank is prepared to
deposit money with another bank. (The second bank must
typically have a AA rating)
• LIBOR was compiled once a day by the British Bankers
Association on all major currencies for maturities up to 12
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months. But later in 2014, due to LIBOR Scandal of 18
superpower banks, BBA BBA has been dismissed from it’s
responsibility.
Later on, ICEB [Inter Continental Exchange Benchmark] took
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•
over the responsibility and publish the LIBOR Rate.
• LIBID [London Interbank Bid Rate] is the rate at which a AA
bank is prepared to pay on deposits from anther bank.
4
LIBOR and LIBID
• The LIBOR rate is published at 11.30 am [UK time]
• Each member bank quote a rate for LIBOR and the highest and
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lowest rate have been omitted from the averaging method of
fixing LIBOR.
• Accordingly; banks borrows funds from an international bank with
a rate of LIBOR + Spread, i.e. LIBOR is considered the risk free
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rate.
• MIBOR, TIBOR, Call Money Rate.
5
The Fed Funds Rate
• Financial Institution are required to maintain a certain amount
or cash of their time and demand deposits or depending on their
outstanding assets and liability.
• Some banks keeps excess reserves with the central bank [FRS].
• So these banks having surplus funds into their reserves with
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FRS are able to lend funds to other banks having deficits into
their reserve.
• Therefore, to met the instant reserve requirement, the banks
with surplus reserve lend funds with an overnight rate.
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• This overnight rate is called Fed Funds Rate.
• A broker usually matches the borrower and lender.
• Starling Overnight Index Average [SONIA], Euro Overnight
Index Average [EONIA].
6
Repo Rates
• Repurchase Agreements an agreement where a financial
institution that owns securities agrees to sell them for a certain
price- X and buy them back in the future(usually the next day)
for a slightly higher price- Y.
• The financial institution hence obtains a loan.
• The rate of interest is calculated from the difference between X
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and Y and is known as the repo rate.
• This is basically done to met up short term fund requirement for
the FIs.
If structured carefully, a repo involves a little credit risk. But in
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•
that case, if the borrower does not honor the agreement, the
lending company simply keeps the securities.
• The Reverse Repo Rate refers to the interest rate paid by a
nation’s central bank when it borrows funds from commercial
banks. The funds are borrowed for a short duration.
Governments use it as a monetary measure to check inflation
and money supply.
7
The Risk-Free Rate
• The short-term risk-free rate traditionally used by
derivatives practitioners is LIBOR
• The Treasury rate (also considered as risk free rate) is
considered to be artificially low for a number of
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reasons (See Business Snapshot 4.1)
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8
Measuring Interest Rates
• The compounding frequency used for an
interest rate is the unit of measurement.
• The difference between quarterly and annual
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compounding is analogous to the difference
between miles and kilometers.
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9
Impact of Compounding
When we compound m times per year at rate R an
amount A grows to A(1+R/m)m in one year
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Compounding frequency Value of $100 in one year at 10%
Annual (m=1) 110.00
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Semi-annual (m=2) 110.25
Quarterly (m=4) 110.38
Monthly (m=12) 110.47
Weekly (m=52) 110.51
Daily (m=365) 110.52
10
Continuous Compounding
• In the limit as we compound more and more
frequently we obtain continuously compounded
interest rates.
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• $100 grows to $100eRT when invested at a
continuously compounded rate R for time T.
• $100 received at time T discounts to $100e-RT at
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time zero when the continuously compounded
discount rate is R.
11
Conversion Formulas (Page 79)
Define
Rc : continuously compounded rate
Rm: same rate with compounding m times
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per year
Rm
R c = m ln 1 +
m
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( )
R m = m e Rc / m − 1
12
Examples
• 10% with semi-annual compounding is
equivalent to 2ln(1.05)=9.758% with continuous
compounding
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• 8% with continuous compounding is equivalent
to 4(e0.08/4 -1)=8.08% with quarterly
compounding
Rates used in option pricing are nearly always
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•
expressed with continuous compounding
13
Zero Rates
The n-year zero-coupon interest rate is the rate of
interest earned on an investment that starts today
and lasts for n years.
Suppose a 5-year zero rate with continuous
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compounding is quoted as 5% per annum. This
means that $100, if invested for 5 years, grows to-
100 X e0.05x5=128.40
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14
Bond Pricing: Example
✓Suppose that a 2-year Treasury bond with a
principal of $100 provides coupons at the rate
of 6% per annum semiannually. To calculate
the present value of the first coupon of $3, we
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discount it at 5.0% for 6 months; to calculate
the present value of the second coupon of $3,
we discount it at 5.8% for 1 year; and so on.
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Maturity (years) Zero rate (cont. comp.)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
15
Bond Pricing
• To calculate the cash price of a bond we discount each
cash flow at the appropriate zero rate
• In our example, the theoretical price of a two-year
bond providing a 6% coupon semiannually is-
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− 0 .05 0 .5 − 0 .058 1.0 − 0 .064 1.5
3e + 3e + 3e
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+ 103e − 0.068 2 .0 = 98.39
16
Bond Yield
• The bond yield is the discount rate that makes the present
value of the cash flows on the bond equal to the market price
of the bond
• Suppose that the market price of the bond in our example
equals its theoretical price of 98.39
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• The bond yield (continuously compounded) is given by solving
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to get y = 0.0676 or 6.76%.
− y 0 .5 − y 1.0 − y 1.5 − y 2 .0
3e + 3e + 3e + 103e = 98.39
17
Par Yield
• The par yield for a certain maturity is the coupon
rate that causes the bond price to equal its face
value.
• In our example we solve.
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c − 0 .05 0 .5 c − 0 .058 1 .0 c − 0 .064 1 .5
e + e + e
2 2 2
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c − 0.068 2.0
+ 100 + e = 100
2
to get c= 6 .87 (with semiannual compoundin g)
18
Par Yield continued…
✓In general if m is the number of coupon payments per
year, d is the present value of $1 received at maturity
and A is the present value of an annuity of $1 on each
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coupon date-
(100 − 100 d ) m
c =
A
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(in our example, m = 2, d = 0.87284, and A =
3.70027).
✓The formula confirms that the par yield is 6.87% per
annum.
19
Zero Rates
• The n year zero-coupon interest rate is the rate of
interest earned on an investment that starts today and
lasts for n years.
• Theoretically in the case of zero coupon bond, n years
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zero coupon interest rate is the n year spot rate.
• Suppose a 5 years zero rate with continuous
compounding is quoted as 5% per annum. This means
that, if $ 100 invested for 5 years, grows to-
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100*e0.05*5= 128.40
20
Data to Determine Zero Curve (Table 4.3, page 82)
Consider the data in the Table on the prices of five bonds.
Because the first three bonds pay no coupons, the zero rates
corresponding to the maturities of these bonds can easily be
calculated.
Options, Futures, and Other Derivatives 8th Edition,
Bond Time to Coupon per Bond price ($)
Principal Maturity (yrs) year ($)*
100 0.25 0 97.5
100 0.50 0 94.9
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100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
* Half the stated coupon is paid each year
21
Rate Calculation of the zero coupon bonds
The 3-month bond has the effect of turning an investment
of 97.5 into 100 in 3 months. The continuously compounded
3-month rate R is therefore given by solving-
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22
The Bootstrap Method
• An amount 2.5 can be earned on 97.5 during 3 months.
• Because 100=97.5e0.10127×0.25 the 3-month rate is 10.127% with
continuous compounding.
• Similarly the 6 month and 1 year rates are 10.469% and 10.536%
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with continuous compounding.
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23
The Bootstrap Method continued
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• To calculate the 1.5 year rate we solve
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to get R = 0.10681 or 10.681%
• Similarly the two-year rate is 10.808%
24
Zero Curve Calculated from the Data (Figure 4.1, page 84)
A chart showing the zero rate as a function of maturity
is known as the zero curve.
12
Zero
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Rate (%)
11
10.681 10.808
10.469 10.536
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10 10.127
Maturity (yrs)
9
0 0.5 1 1.5 2 2.5
25
Forward Rates
• The forward rate is the future zero rate implied by today’s term
structure of interest rates.
• To illustrate how they are calculated, we suppose that zero rates
are as shown in the second column of Table 4.5. These rates are
continuously compounded.
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Year (n) Zero rate for n-year Forward rate for
investment nth year
(% per annum) (% per annum)
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1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5
26
Forward Rates
Options, Futures, and Other Derivatives 8th Edition,
• The forward rate for year 3 is the rate of interest that is implied
by a 4% per annum 2-year zero rate and a 4.6% per annum 3-
year zero rate. It is 5.8% per annum and so on.
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27
Forward Rates
• When Rate is =3% per annum This example simplifies that the
for 1 year means that, in return result from the both events are
for an investment of $100 today, same.
an amount=100e0.03*1 =$103.05 Therefore, Forward rate will be
is received in 1 year. 5.00%
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• The forward interest rate in The forward rate for year 3 is the
rate of interest that is implied by
Table for year 2 is 5% per
a 4% per annum 2-year zero
annum.
rate and a 4.6% per annum 3-
- 100e0.03*1*e0.05*1=$108.33 year zero rate. It is 5.8% per
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annum and so on.
On the other hand-
4% per annum for 2 years for an
investment of $100 today,
100e0.04*2= $108.33 is received in
2 years; and so on.
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Formula for Forward Rates
In general, if R1 and R2 are the zero rates for
maturities T1 and T2, respectively, and RF is the
forward interest rate for the period of time between
T1 and T2, then-
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To illustrate this formula, consider the calculation of
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the year-4 forward rate from the data in Table 4.5;
T1= 3, T2 = 4, R1= 0.046, and R2= 0.05, and the
formula gives RF= 0.062.
Above equation can be written as-
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Formula for Forward Rates
This shows that, if the zero curve is upward sloping
between T1 and T2 so that R2 > R1, then RF > R2
(i.e., the forward rate for a period of time ending at T2
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is greater than the T2 zero rate). Similarly, if the zero
curve is downward sloping with R2 < R1, then RF <
R2 (i.e., the forward rate is less than the T2 zero rate).
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-Taking limits as T2 approaches T1 in the above
equation and letting the common value of the two be
T, we obtain-
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Instantaneous Forward Rate
• WhereR is the zero rate for a maturity of T.
The value of RF obtained in this way is
known as the instantaneous forward rate for
a maturity of T.
Options, Futures, and Other Derivatives 8th Edition,
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Where R is the T-year rate.
31
Upward vs Downward Sloping Yield Curve
• For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield
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• For a downward sloping yield curve
Par Yield > Zero Rate > Fwd Rate
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32
Forward Rate Agreement
• A forward rate agreement (FRA) is an OTC
agreement that a certain rate will apply to a certain
principal during a certain future time period.
• The usual assumption underlying the contract is
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that the borrowing or lending would normally be
done at LIBOR.
• If the agreed fixed rate is greater than the actual
LIBOR rate for the period, the borrower pays the
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lender the difference between the two applied to the
principal.
• If the reverse is true, the lender pays the borrower
the difference applied to the principal.
33
Forward Rate Agreement
• Usually, however, the present value of the payment is made at
the beginning of the specified period.
• Suppose that a company enters into an FRA that is designed to
ensure it will receive a fixed rate of 4% on a principal of $100
million for a 3-month period starting in 3 years. The FRA is an
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exchange where LIBOR is paid and 4% is received for the 3-
month period. If 3-month LIBOR proves to be 4.5% for the 3-
month period, the cash flow to the lender will be-
100,000,000 *(0.04-0.045)*0.25= - $125,000
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• At the 3.25-year point. This is equivalent to a cash flow of-
−125,000
= = − $123,609
1+ (0.045∗0.25)
The vice-versa scenario will be happened to the borrower’s balance
sheet.
34
Things to Remember in FRA
• Consider an FRA where company X is agreeing to
lend money to company Y for the period of time
between T1 and T2. Define-
• RK : The fixed rate of interest agreed to in the FRA
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• RF : The forward LIBOR interest rate for the period
between times T1 and T2, calculated today.
• RM : The actual LIBOR interest rate observed in the
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market at time T1 for the period between times T1
and T2.
• L: The principal underlying the contract.
35
Forward Rate Agreement: Key Results
• Assumptions: T2 -T1 = 0.5, they are expressed with semiannual
compounding; if T2 -T1= 0.25, they are expressed with quarterly
compounding; and so on. (This assumption corresponds to the usual
market practice for FRAs.)
• Normally company X would earn RM from the LIBOR loan. The
FRA means that it will earn R K. The extra interest rate (which may
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be negative) that it earns as a result of entering into the FRA is R K-
RM. The interest rate is set at time T 1 and paid at time T2. The extra
interest rate therefore leads to a cash flow to company X at time T 2
of-
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• L(RK-RM)(T2-T1)
• Similarly there is a cash flow to company Y at time T 2 of
• L(RM-RK)(T2-T1)
36
Forward Rate Agreement: Key Results
As mentioned, FRAs are usually settled at time T1 rather
than T2. The payoff must then be discounted from time
T2 to T1. For company X, the payoff at time T1 is-
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L(RK−RM)(T2−T1)
=
1+RM(T2−T1)
and, for company Y, the payoff at time T1 is-
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L(RM−RK)(T2−T1)
=
1+RM(T2−T1)
37
Value of FRA
• An FRA is worth zero when the fixed rate R K equals the
forward rate RF. When it is first entered into RK is set
equal to the current value of RF, so that the value of the
contract to each side is zero. As time passes, interest
rates change, so that the value is no longer zero.
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Therefore, its value today is the payoff at time T2
discounted at the risk-free rate or
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VFRA=L(RK-RF) (T2 -T1) e-R2T2
And, for the alternative company-
VFRA=L(RF-RK) (T2 -T1) e-R2T2
38
Example
• An FRA entered into some time ago ensures that a
company will receive 4% semi-annually (i.e.- RK=
0.04) on $100 million for six months starting in 1
year
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• Forward LIBOR for the period is 5% semi-annually
(i.e.- RM= 0.05).
• The 1.5 year rate is 4.5% with continuous
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compounding (i.e.- RF= 0.045).
• The value of the FRA (in $ millions) is-
− 0 .045 1 .5
100 ( 0 .04 − 0 .05 ) 0 .5 e = − 0 .467
39
Example continued
• If the six-month interest rate in one year turns out to
be 5.5% (s.a.) there will be a payoff (in $ millions) of-
= 100 X (0.04-0.055) X 0.5 X e0.045x1.5 = -0.8024 M in 1.5
years
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• The transaction might be settled at the one-year
point for an equivalent payoff of-
−0.8024
= = -0.780 million
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1.0275
40
Duration
• The duration of a bond, as its name implies, is a
measure of how long on average the holder of the
bond has to wait before receiving cash payments.
• In other words, duration is used as a measure of
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bond’s interest rate sensitivity of a bond’s full price
to a change in it’s yield.
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41
Duration (page 89-90)
• A zero-coupon bond that lasts n years has a duration
of n years.
• However, a coupon-bearing bond lasting n years has
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a duration of less than n years, because the holder
receives some of the cash payments prior to year n.
• The concept of duration is almost the same as
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Discounted payback period.
42
Duration (Macaulay Duration)
Interpretation of Macaulay Duration:
• It is the weighted average time to the receipts of principle and
interest payment. In other words, You can either wait till the
end of last year to get all your CFs as scheduled, or you can
receive the full payment (=130) on 2.653th year in one shot. In
Options, Futures, and Other Derivatives 8th Edition,
both cases, the result will be the same.
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43
Duration
• Suppose that a bond provides the holder with cash flows c i
at time ti (1≤ i ≤ n). The bond price B and bond yield y
(continuously compounded) are related by-
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• The duration of the bond, D, is defined as-
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• This can be written as- n
ci e − yt i
D = ti
i =1 B
where B is its price and y is its yield (continuously
compounded) 44
Modified Duration
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
• Modified Duration =
1+𝑌𝑇𝑀
Or, when yield y is m times compounded, then-
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D
Modified Duration=
1+ y m
Interpretation:
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- Let’s say, on Modified Duration, if duration of a bond D=3, it says if
the yield y increased by 1%, then the bond’s price will be decreased
by 3% and vice versa.
- In other words, duration is never interchangeable with maturity.
Key Duration Relationship
• Duration is important because it leads to the
following key relationship between the change in
the yield on the bond and the change in its price.
B
= − Dy
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B
Or ΔB = - BDΔy
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• The above equation is an approximate
relationship between percentage changes in a
bond price and changes in its yield.
• As there’s an inverse relationship between B and y,
that’s why the equation got a negative sign.
46
Duration
• For the bond in the table, the bond price, B, is 94.213 and the
duration, D, is 2.653, so that prior equation gives-
ΔB = - 94.213 X 2.653 X Δy
• Or-
ΔB = - 249.95 X Δy
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When the yield on the bond increases by 10 basis points (=0.1%), Δ
y= +0.001. The duration relationship predicts that Δ B = - 249.95 X
0.001= -0.250, so that the bond price goes down to 94.213 - 0.250 =
93.963. How accurate is this-
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Which as same as predicted by the duration relationship.
47
Bond Portfolios
• The duration for a bond portfolio is the weighted
average duration of the bonds in the portfolio with
weights proportional to prices.
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• The key duration relationship for a bond portfolio
describes the effect of small parallel shifts in the
yield curve
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• What exposures remain if duration of a portfolio of
assets equals the duration of a portfolio of
liabilities?
48
Bond Portfolios
• The duration relationship
applies only to small changes
in yields. This is illustrated in
the figure which shows the
relationship between the
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ΔB
percentage change in value 𝐵
𝐵and change in yield (Δy) for
two bond portfolios having the
same duration.
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49
Convexity
The convexity, C, of a bond is defined as
n
1 2B
ci t i2 e
− yti
i =1
C= =
B y 2
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B
This leads to a more accurate relationship
B 1
= − D y + C ( y )
2
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B 2
When used for bond portfolios it allows larger shifts
in the yield curve to be considered, but the shifts
still have to be parallel.
50
Theories of the Term Structure
• Expectations Theory: forward rates equal
expected future zero rates.
• Market Segmentation: short, medium and long
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rates determined independently of each other.
• Liquidity Preference Theory: forward rates
higher than expected future zero rates.
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51
Liquidity Preference Theory
• Suppose that the outlook for rates is flat and
you have been offered the following choices
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Maturity Deposit rate Mortgage rate
1 year 3% 6%
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5 year 3% 6%
• Which would you choose as a depositor?
Which for your mortgage?
52
Liquidity Preference Theory
cont
• To match the maturities of borrowers and lenders a
bank has to increase long rates above expected future
short rates
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• In our example the bank might offer
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Maturity Deposit rate Mortgage rate
1 year 3% 6%
5 year 4% 7%
53
Practice Questions
Options, Futures, and Other Derivatives 8th Edition,
• All Practice Questions- 4.1- 4.24
• Farther Questions- 4.26, 4.29, 4.30
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54
The End ☺
55
