BITS Pilani

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Interest Rates

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Types of Rates

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Types of Rates
Treasury Rate: Rate on instrument issued by a government in its own currency
LIBOR: (London Interbank Offered Rate) Rate at which a AA bank can borrow money
on an unsecured basis from another bank; Published by the British Bankers
Association at 11 AM. The borrowing period ranges from 1 day to 1 year.
Risk-free Rate: Derivative traders use the LIBOR or rates implied by T Bills as the
risk free rate
Interest rates are often expressed in basis points.
• One basis point = 0.01% pa

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Periodic and Continuous Compounding
Compounding m times per year at rate R, A grows in t years to A(1+R/m)mt
Letting m ∞, we have continuous compounding
When we continuously compound at rate R, A grows in t years to AeRt
The accumulation at the end of t years may be discounted at the discount rate R
(compounded m times per year or continuously compounded as the case may be) to compute
the initial deposit.
Rates used in option pricing are nearly always expressed with continuous compounding

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Periodic and Continuous Compounding

Compounding frequency Value of $100 in one year at 10%

Annual (m=1) 110.00
Semiannual (m=2) 110.25
Quarterly (m=4) 110.38
Monthly (m=12) 110.47
Weekly (m=52) 110.51
Daily (m=365) 110.52
Continuous 110.52

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Periodic & Continuous Compounding
Rc : continuously compounded rate
Rm: same rate with compounding m times per year

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Example 1

We have 10%pa with semiannual compounding. What is the equivalent rate with
continuous compounding?

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Example 1

We have 10%pa with semiannual compounding. What is the equivalent rate with
continuous compounding?

 = 2*ln(1 + 0.10 / 2) = 2*ln(1.05) = 9.758% pa (continuous compounding)

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Example 2

We have 8%pa with continuous compounding. Find the equivalent rate when we
have quarterly compounding.

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Example 2

We have 8%pa with continuous compounding. Find the equivalent rate when we
have quarterly compounding.

 = 4(e0.08/4 -1) = 8.08%pa with quarterly compounding

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Interest Rates
• Simple Interest
• Interest Compounded
• Interest Continuously Compounded

• Interest on short-term financial instruments is usually simple rather than

compound
• Compound interest is used almost exclusively for financial transaction covering a
period of one year or more
• We shall assume the interest rate is
• Continuously compounded for transactions covering periods of one year or
more unless explicitly stated otherwise
• Simple for transactions covering periods of less than one year unless explicitly
stated otherwise
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Term Structure of Interest Rates

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Zero Rates or Spot Rate
A zero rate (or spot rate), for maturity T is the rate of interest earned on an
investment that provides a payoff only at time T

Maturity (years) Zero rate (cont. comp.)

0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

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Example 3
What is the spot rate (cont. comp.) for the ZCB with the following features?
• Face Value = $100 (Par Value or Principal)
• Price = $97.5310
• Time to maturity = 6m

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Example 3
What is the spot rate (cont. comp.) for the ZCB with the following features?
• Face Value = $100 (Par Value or Principal)
• Price = $97.5310
• Time to maturity = 6m

97.5310*e
  0.5*i
= 100
i = 2 * ln(100/97.5310) = 0.05 = 5%pa (cont. comp.)

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The Term Structure of Interest Rates
The term structure describes the relationship of spot rates with different maturities.

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Example 4

Determine the Term Structure of Interest Rates given the data below,
using the Bootstrap Method.

Bond Principal Time to Maturity Coupon per year Bond price

($) (yrs) ($)* ($)
100 0.25 0 99.6
100 0.50 0 99.0
100 1.00 0 97.8
100 1.50 4 102.5
100 2.00 5 105.0
*
Half the stated coupon is paid every six months

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Example 4
Bond Principal ($) Time to Maturity (yrs) Coupon per year ($)* Bond price ($)

100 0.25 0 99.6

100 0.50 0 99.0
100 1.00 0 97.8
100 1.50 4 102.5
100 2.00 5 105.0
*
Half the stated coupon is paid every six months

Since 100=99.6e0.01603×0.25 The 3-month spot rate is 1.603% with continuous compounding
Similarly the 6 month spot rate is 2.010% with continuous compounding
Similarly the 1 year rate is 2.225% with continuous compounding

Solving 2e-0.02010*0.5 + 2e-0.02225*1.0 + 102e-R*1.5 = 102.5 we get the 18-month spot rate as 2.284%
Similarly the two-year rate is 2.416%

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Example 4: The Zero Curve

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Bond Pricing

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Bonds*
The three main generic asset classes: Equity, Fixed-income Securities & Cash equivalents

Characteristics of a Bond
• Face value: The value of the bond at maturity
If an investor purchases a bond at a premium $1,090 and another purchases the same
bond at a discount $980. When the bond matures, both investors will receive the $1,000
face value of the bond.
• Coupon rate: The rate of interest paid on the face value of the bond
• Coupon dates: Dates on which interest payments are made
Typical intervals are annual or semi-annual coupon payments.
• Maturity date: Date on which the bond will mature
• Issue price: The price at which the bond issuer originally sells the bonds.

• Bonds may be publicly traded on exchanges, or may be traded only OTC

* https://www.investopedia.com/terms/b/bond.asp

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Example 5
Treasury Zero Rates (Cont Comp)
Maturity (years) Zero rate
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

A 2-year Treasury bond with a principal of $100 provides coupons at the rate of 6%
per annum semiannually. Compute the bond price using the zero rates given above

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Example 5
Treasury Zero Rates (Cont Comp)
Maturity (years) Zero rate
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

A 2-year Treasury bond with a principal of $100 provides coupons at the rate of 6%
per annum semiannually. Compute the bond price using the zero rates given above

Current time be 0
Cash Inflows: $3 at times 0.5, 1.0, 1.5 and $103 at time 2
PV(cash inflows) = 3e-.05*0.5 + 3e-.058*1 + 3e-.064*1.5 + 103e-.068*2 = 98.39
Theoretical Price = $98.39
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Example 6*: Bond Yield

A 2-year Treasury bond with a principal of $100 provides coupons at the rate of 6%
per annum semiannually. The price is $98.39. What is the bond yield?

* Out of Course

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Example 6*: Bond Yield

A 2-year Treasury bond with a principal of $100 provides coupons at the rate of 6%
per annum semiannually. The price is $98.39. What is the bond yield?

Cash Inflows: $3 at times 0.5, 1.0, 1.5 and $103 at time 2

The bond yield (continuously compounded) is given by solving

3e-y*0.5 + 3e-y*1.0 + 3e-y*1.5 + 103e-y*2.0= 98.39

y = 0.0676 or 6.76%.

* Out of Course

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Bond Yield or YTM
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

• Assumes all coupon payments are reinvested at the same rate as the current yield
• Factors in the market price, par value, coupon interest rate, and term to maturity
• Can be used to compare bonds with different maturities and coupons

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Exercise 7
Given the following term structure of interest rates, find the price of a bond that pays
Rs.1000 at the end of each year for five years. Assume the interest rates are annually
compounded.
Maturity (years) 1 2 3 4 5
Rate (%pa) 7.0 8.0 8.75 9.25 9.5

y r Payout PV(Payout)
1 7 1000 934.5794
2 8 1000 857.3388
3 8.75 1000 777.5211
4 9.25 1000 701.9630
5 9.5 1000 635.2277
Price 3906.6301

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Duration

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Duration of a Bond
• Is a measure of how long on average an investor has to wait before receiving
payments
• Duration is expressed as a number of years
• Bond prices have an inverse relationship with interest rates – rising interest rates
indicate bond prices are likely to fall, while declining interest rates indicate bond
prices are likely to rise
• Duration is also a measure of the sensitivity of the bond price to a change in interest
rates

• Duration of a ZCB is the time to maturity

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Duration

Duration of a bond that provides cash flow ci at time ti:

where B is its price and y is its yield (continuously compounded)

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Key Duration Relationship
&

Yields go higher, price goes lower & vice versa

For small changes in the yield

When the yield y is expressed with compounding m times per year,

Modified Duration:

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Bond Portfolios

The duration for a bond portfolio is the weighted average duration of the bonds in
the portfolio with weights proportional to prices
The key duration relationship for a bond portfolio describes the effect of small
parallel shifts in the yield curve

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Convexity

• X and Y are two bond portfolios

• At , X & Y have the same tangent / gradient
• X & Y have the same duration
• X & Y change in value by the by the same % for
small yield changes
• If is large, X changes at a faster rate since the curve
for X has more curvature
• Convexity measures curvature

• The relationship between price and yield is convex in

nature

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Example 8

What exposures remain if duration of a portfolio of assets equals the duration of a

portfolio of liabilities?

The net duration is 0

Exposure to small parallel changes in the yield curve is 0
Exposure to large or non-parallel shifts still remains

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Exercise 9
A 5-year bond with a yield of 11% (cont. Comp.) and face value of $100 pays an 8% coupon
at the end of each year.
A. What is the bond’s price?
B. What is the bond’s duration?
C. Use the duration to calculate the effect on the bond’s price of a 0.2% decrease in the
yield.
D. Recalculate the bond’s price on the basis of 10.8% pa yield and verify that the result is in
agreement with your answer to Part C.

a.
  Price = 8e-0.11*1 + 8e-0.11*2 + 8e-0.11*3 + 8e-0.11*4 + 108e-0.11*5 = 86.8011
b. D = (1/86.80)(1*8e-0.11*1 + 2*8e-0.11*2 + 3*8e-0.11*3 + 4*8e-0.11*4 + 5*108e-0.11*5) = 4.2560 years
c. = -86.8011 * 4.2560 * (-0.002) = 0.74 Price will increase by $0.74
d. Price = 8e-0.108*1 + 8e-0.108*2 + 8e-0.108*3 + 8e-0.108*4 + 108e-0.108*5 = 87.54

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 Exercise 10

 a) Portfolio A: Price = 2000e-0.1 + 6000e-0.1*10 = 4016.95

Duration = (1/4016.95)*(1* 2000e-0.1 + 10*6000e-0.1*10) = 23882.44/4016.95 = 5.95
Portfolio B: Price = 5000e-0.1*5.95 = 2757.81; Duration = 5.95
b) Portfolio A: = -4016.95*5.95*0.001 = -23.90 % change = -23.90/4016.95 = -0.59%
Portfolio B: = -2757.81*5.95*0.001 = -16.41 % change = -16.41/2757.81 = --0.59%
c) Portfolio A: Price = 2000e-0.15 + 6000e-0.15*10 = 3060.20 % reduction = 23.82%
Portfolio B: Price = 5000e-0.15*5.95 = 2048.15 % reduction = 25,73%

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Forward Rates

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Forward Rates
The forward rate is the future zero rate implied by today’s term structure of
interest rates

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Formula for Forward Rates
Suppose that the zero rates for time periods T1 and T2 are R1 and R2 with both rates
continuously compounded.
The forward rate for the period between times T1 and T2 is

This formula is only approximately true when rates are not expressed with
continuous compounding

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Example 11
Compute the forward rates given the zero rates (cont. comp) below.
Year (n) Zero rates (% pa) Forward rate (% pa)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 7.5

Let
  rab be the forward rate for the period (a, b)

 
 %  
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Forward Rate Agreement (FRA)

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FRA
• An OTC agreement
• A specified notional principal amount
• Party A pays a fixed interest rate (FRA Rate)
• Party B pays a floating interest rate
• For a specified future time period
• Cash settled

• Party A is the buyer (paying the fixed interest rate)

• Party B is the seller

• The buyer protects itself from rising rates

• The seller protects itself from falling rates
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Example 12
Bank A sells to Bank B a 3 X 6 FRA at 10% against a floating 91-day T-Bill rate with
notional principal of $10 million
• 3 X 6 denotes the start date and the maturity date
• Bank A receives a fixed 10% on the NP for a 3-month period starting 3 months
from trade date
• Bank B receives floating rate on the NP for the same period. The floating rate
would be the 91-day T-Bill arte 3 months from start date
• The net amount is due on maturity – 6 months from trade date
• But settlement is done on the start date – 3 months from trade date

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Example 13
A corporation knows it will borrow $1000 000 in six months' time for a 6-month period.
The interest rate at which it can borrow today is 6-month Libor plus 50 basis points.
Let us further assume that the 6-month Libor currently is at 0.89465% pa, but the
company’s treasurer thinks it might rise as high as 1.30% over the coming months.
What should the treasurer do?

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Example 13
A corporation knows it will borrow $1000 000 in six months' time for a 6-month period.
The interest rate at which it can borrow today is 6-month Libor plus 50 basis points.
Let us further assume that the 6-month Libor currently is at 0.89465% pa, but the
company’s treasurer thinks it might rise as high as 1.30% over the coming months.
What should the treasurer do?

The treasurer will buy a 6x12 FRA in order to protect itself from rising rates

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Example 14
A corporation knows it will borrow $1000 000 in six months' time for a 6-month period.
The interest rate at which it can borrow today is 6-month Libor plus 50 basis points.
Let us further assume that the 6-month Libor currently is at 0.89465% pa, but the
company’s treasurer thinks it might rise as high as 1.30% over the coming months.
The bank offers a 6X12 FRA where the corporation will pay a fixed rate of 0.95560%
pa in exchange for LIBOR on a NP of $1 million. The treasurer buys the FRA.
Describe the cash transactions (no computations)
At t = 0.5
• 6-month LIBOR is identified
• If LIBOR > 0.95560%, Bank will pay the corporation
• If LIBOR < 0.95560%, the corporation will pay the bank
• If LIBOR = 0.95560%, Zero settlement amount
• Amount Paid
• PV[(LIBOR – 0.95560%) * 0.5 * 1,000,000]
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Example 15
A corporation knows it will borrow $1000 000 in six months' time for a 6-month period. The interest rate
at which it can borrow today is 6-month Libor plus 50 basis points. Let us further assume that the 6-
month Libor currently is at 0.89465% pa, but the company’s treasurer thinks it might rise as high as
1.30% over the coming months.
The bank offers a 6X12 FRA where the corporation will pay a fixed rate of 0.95560% pa in exchange
for LIBOR on a NP of $1 million. The treasurer buys the FRA.
Suppose 6 months from now, the 6-month LIBOR is 1.26222% pa.
Compute the cash settlement

Corporation
  buys the FRA
Corporation pays 0.95560% on NP and receives 1.26222% (LIBOR) on NP
• Interest differential: 1.26222% − 0.95560%
• Net amount due on maturity: (1.26222% − 0.95560%) * 0.5 * 1 000 000 = $1 533.10
• Amount paid on settlement date: 1533.10 / [1 + 1.26222% × 0.5] = $1523.49
• Corporation receives $1523.49

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Example 16
A corporation knows it will borrow $1000 000 in six months' time for a 6-month period. The interest rate
at which it can borrow today is 6-month Libor plus 50 basis points. Suppose the 6-month Libor
currently is at 0.89465% pa, but the treasurer thinks it might rise as high as 1.30% over the coming
months.
The bank offers a 6X12 FRA where the corporation will pay a fixed rate of 0.95560% pa in exchange
for LIBOR on a NP of $1 million. The treasurer buys the FRA.
If 6 months from now, the 6-month LIBOR is 1.26222% pa, the corporation will receive $1523.49.
Compute the locked in borrowing rate.
Assume t = 0.5
Corporation requires $1,000,000 for 6 months
It borrows or 6 months at 1.26222% pa

At t = 1
It closes the loan by paying off the Principal + Interest – Amount Due from FRA
= 1 million + (1 million * 1.26222% * 0.5) – 1533.10 = = 1 million + 8811.10 – 1533.10
Effective Interest Paid: 7278
Effective Interest Rate: 7278 / (1000000*0.5) = 1.4556%
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Example 17

An FRA entered into some time ago ensures that a company will receive 4% (p.a.)
on $100 million for six months starting in 1 year and pay LIBOR
Forward LIBOR for the period is 5% (p.a.)
The 1.5 year risk-free rate is 4.5% with continuous compounding
Compute the value of the FRA to the company.

The value of the FRA (in $ millions) is

100 * (0.04 - 0.05) * 0.5 * e -0.045*1.5 = -0.467

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Example 18
An FRA entered into some time ago ensures that a company will receive 4% (p.a.) on
$100 million for six months starting in 1 year and pay LIBOR.
At expiry of the FRA, the six-month LIBOR interest rate turns out to be 5.5% (p.a.)
A. Compute the payoff in 6 months
B. Compute the settlement amount.

In 6 months, the company will receive 100 * (0.04 – 0.055) * 0.5 = -0.75 million

B. The transaction will be settled at –0.75 / (1 + 0.055*0.5) = -0.73 million (approx.)

More precisely, the company will pay $7,29,927

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Example 19*
FRA Rate 1.5%
LIBOR Fix 2.0%
Notional Principal $1,000,000
Contract Period (Days) 181
Day-Count Convention Year 360
Settlement Amount $2,513.89
Discount Factor 0.990044552
Payment Amount $2,488.86
Show the locked-in interest rate is the FRA Rate

https://thismatter.com/money/derivatives/forward-rate-agreements.htm
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Example 20
A bank can borrow or lend at LIBOR. Suppose that the six-month rate is 5% and the
nine-month rate is 6%. Design an FRA? (Assume all rates are continuously
compounded & there are no transaction costs.)
  The forward rate is = FRA Rate

The bank can offer 6X9 FRA at 8%

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Forward Rate Agreement: Key Results
Consider an FRA where X is agreeing to lend money to Y for the period T1 – T2
Define:
RK: The rate of interest agreed to in the FRA
RF : The forward LIBOR interest rate for the period T1 – T2 , calculated today
RM : The actual LIBOR interest rate observed in the market at time T1 for the period T1 – T2
L: The principal underlying the contract.
RF and RK are expressed with a compounding frequency corresponding to the length T2 – T1

Y: Buyer
Cash Flow to Buyer:

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Valuation Formulas
Consider an FRA where X is agreeing to lend money to Y for the period T1 – T2
Define:
RK: The rate of interest agreed to in the FRA
RF: The forward LIBOR interest rate for the period T1 – T2 , calculated today
RM: The actual LIBOR interest rate observed in the market at time T1 for the period T1 – T2
rt: The risk free rate for maturity T2
L: The principal underlying the contract.

t = 0: RK is set equal to current value of RF

t = T1: If RM = RK then cash flow to Buyer =
T = t: PV(Cash Flow to Buyer) =

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