Interest Rates

AF5351 Derivative Securities

Shixiang Xia
Why do we care about interest rates?
• There are derivatives on interest rates
• Interest futures
• Interest rate swap
• Interest rates are an important factor in valuation
of derivatives
• Borrowing/lending rates
• Need to know the proper discount rate to calculate PV

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Outline
• Types of interest rates
• How to measure interest rates
• Compounding
• Bond basics
• Forward rates

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Types of Rates
•Treasury rate
•LIBOR
•Fed funds rate
•Repo rate
•OIS
•“Risk-free” rate

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Treasury Rate
• Rate on instrument issued by a government in its own currency
• Treasury Bills: zero-coupon bonds; issued weekly; maturities of 4,
13, 26, 52 weeks
• Treasury Notes: coupon bonds (semi-annual payments); maturities
between 2 and 10 years (2, 3, 5, 7, 10 years)
• Treasury Bonds: coupon bonds (semi-annual payments); maturities
between 20 and 30 years
• Treasury Inflation-Protected Securities (TIPS): principal adjusted to
CPI; coupon bonds (semi-annual payments); maturities of 5, 10, 30
years

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London Interbank Offered Rate
(LIBOR)
• LIBOR is the rate of interest at which a major global bank can borrow
money on an unsecured basis from another bank
• That is, Interest rate at which a banks is willing to deposit money with another bank

• For 5 currencies and 7 maturities ranging it is calculated daily by the

submissions from a number of major banks
• USD, EUR, JPY, GBP, CHF
• overnight/spot next, one week, and one, two, three, six, and 12 months

• Before 2007, LIBOR is the interest rate commonly used for derivatives
pricing as it is the "risk free" opportunity cost of financial institutions

• According to the Federal Reserve and regulators in the UK, LIBOR will
be phased out by June 30, 2023, and will be replaced by the Secured
Overnight Financing Rate (SOFR)

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The U.S. Fed Funds Rate
• In the USA, banks have to hold reserves in Federal Reserve Bank
• To meet requirements banks trade balances held at the Federal
Reserve with each other
• Unsecured interbank overnight rate of interest
• Allows banks to adjust the cash (i.e., reserves) on deposit with the
Federal Reserve at the end of each day
• The effective fed funds rate is the average rate on brokered
transactions
• Federal funds target rate is set by the Federal Open Market
Committee
• Federal Reserve Bank actively trades in the treasury market to achieve the target rate
• Similar arrangements in other countries

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 Repurchase Agreement
(Repo Rate)
• Repurchase agreement is an agreement where a financial
institution that owns securities agrees to sell them for X and buy
them back in the future (usually the next day) for a slightly higher
price, Y
• The financial institution obtains a loan.
• The rate of interest is calculated from the difference between X and
Y and is known as the repo rate
• Equivalent to collateralized loan
• Almost risk free

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OIS rate
• An overnight indexed swap (OIS) is swap where a
fixed rate for a period (e.g. 3 months) is exchanged
for the geometric average of overnight rates (e.g.
effective fed fund rate) during the period
• OIS longer than one year is typically divided into
three-month subperiods
• At the end of each subperiod, the geometric average of the
overnight rates during the subperiod is exchanged for the
OIS rate.
• The OIS rate is a continually refreshed overnight rate

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 The Risk-Free Rate
• Risk-free rate plays a central role in derivatives pricing

• Usual approach to value derivatives is to set up riskless portfolio and

argue the return should be risk-free rate

• OIS rates are now used as a proxy for risk-free rates in derivatives
valuation

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Measuring Interest Rates

•The compounding frequency used for an interest rate is the

unit of measurement
•The difference between quarterly and annual compounding is
analogous to the difference between miles and kilometers
• They are two different units of measurement.

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Compounding of Interest Rates (I)
• The compounding frequency is the unit of measurement for interest
rates

• The effective annual interest rate (or annual equivalent rate) depends
on the compounding frequency of the stated annual interest rate

• Compounding m-times per annum at rate r yields the effective annual

interest rate is
𝑟 𝑚
1+ −1
𝑚

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Compounding of Interest Rates (II)
•In the limit as we compound more and more frequently we obtain
continuously compounded interest rates (c.c.)
•$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 time zero when the
continuously compounded discount rate is r
•In continuous compounding, the effective annual interest rate is
𝑒𝑟 − 1

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Conversion Formulas
Define
Rc : continuously compounded rate
Rm: same rate with compounding m times per year

 Rm 
Rc = m ln 1 + 
 m 

( )
Rm = m e Rc / m − 1

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Examples
• 10% with semi-annual compounding is equivalent to 2ln(1.05)=9.758%
with continuous compounding

• 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 expressed with continuous
compounding

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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

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

Annual (m=1) 110.00
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

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 Zero (Spot) Rates
• A zero rate (or spot rate) at time t, for maturity T - t is the rate of interest
earned on an investment that provides a payoff only at time T
•Instantaneous spot rate at time t for a maturity T-t → 0 is called short rate
•Illustration of the term structure of interest rates (yield curve) at time t:

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Bond Pricing
• A bond is a contract which promises future cash flows C (coupons) at time {0,1 , 2 , ..., T }
• Time T is the maturity of the bond

PAR VALUE
• A zero-coupon bond does not pay any coupons but some face value F at maturity PRINCIPAL
• To calculate the cash price of a bond we discount each cash flow at the appropriate zero rate

R_t, t+1 = 5.8%

• In the example above, the theoretical price of a two-year bond providing a 6% coupon
semiannually (F=100) is

3e −0.05 0.5 + 3e −0.0581.0 + 3e −0.064 1.5

+ 103e − 0.068 2 .0 = 98.39
C = F * 6% * 1/2 = 3

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Bond Yield
•The bond yield is the (constant) discount rate that makes the present value
of the cash flows on the bond equal to the market price of the bond
•The bond yield is a weighted average of the spot rates
•The yield of a (risk free) zero-coupon bond with T-years maturity is equal to
the T-year spot rate
•In general (except for some simple cases), we need a good calculator with
optimization tools or computer software like Excel to solve numerically
•Suppose that the market price of the bond in our example equals its
theoretical price of 98.39
• 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

to get y = 0.0676 or 6.76%.

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Par Yield
•The par yield for a certain maturity is the (constant) coupon rate
that causes the bond price to equal its face value.
•In our example we solve (semi-annually)
c −0.050.5 c −0.0581.0 c −0.0641.5
e + e + e
2 2 2
 c
+ 100 + e −0.0682.0 = 100
 2
to get c=6.87

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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 coupon date

(100 − 100 d ) m
c=
A
(in our example, m = 2, d = 0.87284, and A = 3.70027)

𝑑 = 𝑒 −0.068∗2
A = 𝑒 −0.05∗0.5 + 𝑒 −0.058∗1 + 𝑒 −0.064∗1.5 + 𝑒 −0.068∗2

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Data to Determine Zero Curve

Bond Principal Time to Coupon per Bond price ($)

Maturity (yrs) year ($)*
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 each 6 months

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The Bootstrap Method
•An amount 0.4 can be earned on 99.6 during 3 months.

•Because 100=99.6e0.01603×0.25 , the 3-month rate is 1.603% with continuous

compounding

•Similarly the 6 month and 1 year rates are 2.010% and 2.225% with continuous
compounding

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The Bootstrap Method continued

To calculate the 1.5 year rate we solve

2e −0.020100.5 + 2e −0.022251.0 + 102e − R1.5 = 102.5

to get R = 0.02284 or 2.284%

Similarly the two-year rate is 2.416%

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Zero Curve Calculated from the Data
3.00% Zero Rate
(% per annum)
2.50%

2.00%

1.50%

1.00%

0.50%
Maturity (years)
0.00%
0 0.5 1 1.5 2 2.5 3

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Duration
•The Macaulay duration of a bond is a measure of how long on average the
bondholder will be repaid the bond’s price by the its total cash flows
•Weighted average of times of cash flows
•Macaulay Duration of a bond that provides cash flow ci at time ti is
n
 ci e − yt i 
D =  ti  
i =1  B 
where B is its price and y is its yield (continuously compounded)
•Macaulay Duration of a bond is large (small) if the bond pays out much of
its cash flows late (early) in time

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Duration example

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 Key Duration Relationship
•Duration is important because it leads to the following key
relationship between the change in the (c.c.) yield on the bond
and the change in its price
B
= − Dy
≈
B

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 Key Duration Relationship continued

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

𝐵𝐷Δ𝑦
Δ𝐵 ≈ −
1 + 𝑦/𝑚

•The expression
D
1+ y m

is referred to as the “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 is valid when

we consider the effect of small parallel shifts in the yield curve

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Convexity
•The convexity, C, of a bond is defined as
n

1 2B

i =1
ci t i2 e − yti
C= =
B y 2
B
•This leads to a more accurate relationship
Δ𝐵 1 2
≈ −𝐷Δ𝑦 + 𝐶 Δ𝑦
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

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

•The forward rate at time t for period [T1,T2] with t < T1 < T2 is the
future interest rate at which buyer and seller (lender and borrower)
are willing to agree at time t to trade in the future (at time T1) a risk
free zero-coupon bond (or an equivalent credit contract) with
maturity at time T2 (and no money is exchanged today)

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Formula for Forward Rates (I)
•Suppose that the zero rates for time periods T1 – t and T2 – t are rt,T1 and rt,T2
with both rates continuously compounded.
(𝑇1 ,𝑇2 )
•The forward rate 𝑓𝑡 for the period between times T1 and T2 is

•Derivation will be given in the next few slides

•This formula is only approximately true when rates are not expressed
with continuous compounding (next slide)

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 Formula for Forward Rates (II)
•Suppose that the zero rates for time periods T1 – t and T2 – t are rt,T1 and rt,T2
with both rates compounded m-times per annum.

(𝑇1 ,𝑇2 )
•The forward rate 𝑓𝑡 for the period between times T1 and T2 is

•Derivation will be given in the next few slides

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Derivation of Forward Rates
(continuous)

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Derivation of Forward Rates
(m-times, I)

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Derivation of Forward Rates
(m-times, II)

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Instantaneous Forward Rate
•The instantaneous forward rate at time t for a maturity date T1 is the
forward rate that applies for a very short time period starting at T1. It is

(𝑇 ) 𝜕𝑟𝑡,𝑇1
𝑓𝑡 1 = 𝑟𝑡,𝑇1 + 𝑇1 − 𝑡
𝜕𝑇1

where 𝑟𝑡,𝑇1 is the (T1 -t) - year rate

(𝑇1 ,𝑇2 )
•Derivation: simply compute lim 𝑓𝑡 in the continuously
𝑇2 →𝑇1
compounded case.

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Arbitrage Opportunity (I)

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Arbitrage Opportunity (II)

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Forward Rate numerical example

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Forward Rate Agreement
• A forward rate agreement (FRA) is an OTC agreement at time t that a certain
rate will apply to a certain principal during a certain future time period [T1, T2]
• A FRA is a forward contract on an interest rate (not on a bond, or a loan).
• The buyer effectively has agreed to borrow an amount of money in the future
at the stated forward (contract) rate. The seller has effectively locked in a
lending rate.
• The buyer of a FRA profits from an increase in interest rates. The seller of a
FRA profits from a decline in rates.
• FRA’s are cash settled.

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Forward Rate Agreement

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Forward Rate Agreement

t1 t2
0
origination date
Loan period
settlement date, or end of forward
delivery date period

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Forward Rate Agreement
•FRAs are used by many institutions to hedge unexpected
changes in the interest rate
•FRAs exist on all major currencies in the world
•Market for FRA is quite liquid; bid-ask spreads are only 3 or
4 basis points
•As substitutes of FRAs there are also futures contracts
traded on short-term credit instruments

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FRA “Jargon”

• A t1 X t2 FRA: The start date, or delivery date, is t1 months hence. The end
of the forward period is t2 months hence. The loan period is t1-t2 months
long.

• E.g., a 9 X 12 FRA has a contract period beginning nine months hence,

ending 12 months hence.

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Payoff of a Forward Rate Agreement

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Valuation Formulas

𝑇2

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Example

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