10/9/2024

What are interest rates?

Time value of money: how much is worth
Interest Rates and Fixed today one dollar paid in the future?
Income Debt is the life blood of the modern economy
Governments, companies and consumers
borrow money.
Interest rates are a major determinant of the
value of these liabilities

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Interest compounding
Savings institutions (banks, money market funds)
pay interest income on deposits
An initial deposit grows in time by interest
compounding
Interest is accrued periodically (daily, monthly,
yearly). An interest rate must be quoted together
with its accrual frequency.

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Outline of class Types of Rates

A wide variety of interest rates:
Types of interest rates
Zero rates
Measuring interest rates: discrete and continuous
compounding LIBOR, now SOFR
Swap rates
Yield curve: a snapshot of today’s interest rates.
Determining the yield curve from data Treasury rates
Fed funds rate
Bonds and their valuation and risk: duration and
Repo rates
convexity
…

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Zero Rates Quoting Interest Rates

The zero rate (or spot rate) R(T), for maturity T is The compounding frequency used for an interest
the rate of interest earned on an investment that rate is important
provides a payoff only at time T The difference between quarterly and annual
compounding is analogous to the difference
between miles and kilometers
Defined in terms of the discount factor D(T) – the
value today of a dollar paid at time T - as

D(T) = exp(-R(T) T)

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Impact of Compounding Continuous Compounding

(Page 82-83)
When we compound m times per year at rate R an In the limit as we compound more and more
amount A grows to A(1+R/m)m in one year
frequently we obtain continuously compounded
Compounding frequency Value of $100 in one year at 10% interest rates
Annual (m=1) 110.000 $100 grows to $100eRT when invested at a
Semiannual (m=2) 110.250
continuously compounded rate R for time T
Quarterly (m=4) 110.381
Monthly (m=12) 110.471
$100 received at time T discounts to $100e-RT at
Weekly (m=52) 110.506
time zero when the continuously compounded
Daily (m=365) 110.515 discount rate is R
Continuous (m→∞) 110.517

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Conversion Formulas (Page 83) Examples

Define 10% with semi-annual compounding is
equivalent to 2ln(1.05)=9.758% with
Rc : continuously compounded rate
continuous compounding
Rm: same rate with compounding m times per
8% with continuous compounding is
year
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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LIBOR The new reference rates

LIBOR used to be the benchmark for interbank
borrowing rates (until June 2023).
This was the rate of interest at which a AA-rated
bank could borrow money on an unsecured basis US dollar: SOFR (secured overnight funding rate)
from another bank GBP: SONIA (sterling overnight index average
LIBOR was open to manipulation, and became EU: ESTR (euro short-term rate), co-exists with
controversial after several manipulation attempts EURIBOR
were uncovered.
Switzerland: SARON (Swiss average overnight
For this reason it was phased out over the past 5
rate)
years. It ceased being published in June 2023.
Japan: TONAR (Tokyo average overnight rate)
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Repo rate Tri-party repo

Repurchase agreement is a type of short-term
borrowing 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 Example: hedge fund borrows cash from a
the repo rate money market fund using a financial institution
(dealer) as intermediary

SOFR Treasury Rate

The repo market is the lifeblood of Wall Street Rate on instruments issued by a government
The gross size of this market is about $5.1 in its own currency
trillion In the US, the US Treasury issues debt
The SOFR rate is calculated daily by the instruments:
Federal Reserve from repo rates: Treasury Bills (1m, 3m, 6m, 1y)
Secured Treasury Notes (2Y, 5Y, 7Y)
Treasury Bonds (10Y,30Y) 100Y?
Overnight rate (1-day)
[Link]
Funding rate

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Normal shape of the Treasury curve Yield Curve Properties/Assumptions

Zero rates should be positive

Yield curve should be increasing(?)
Normal vs. Inverted yield curves

Bond investors expect to be paid more for long-term bonds

than for short-term bonds.
Once in a while, short-term rates rise above long-term
rates. This is called an inverted yield curve, and it is
Published daily at [Link]
considered to anticipate a recession.
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Recent Treasury yield curve The U.S. Fed Funds Rate

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
The central bank may intervene with its own
transactions to raise or lower the rate
Similar arrangements in other countries

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Bonds Bond Pricing

Simplest debt instrument: issued by To calculate the cash price of a bond we
governments, municipalities or corporations discount each cash flow at the appropriate
Pays coupons (fixed or floating, linked to a zero rate
reference rate) [For this lecture:] Assume bond issuer will
Can be non-callable or callable never default
May be converted to shares of the issuing
company (convertible bonds)

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Bond Yield
Example (Table 4.2, page 84)
The bond yield is the discount rate that makes
Maturity (years) Zero rate (cont. comp.)
the present value of the cash flows on the
0.5 5.0
bond equal to the market price of the bond
1.0 5.8
1.5 6.4 Suppose that the market price of the bond in
2.0 6.8 our example equals its theoretical price of
98.39
Example: the theoretical price of a two-year bond providing a 6% coupon The bond yield (continuously compounded) is
semiannually is
given by solving

to get y=0.0676 or 6.76%.

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Par Yield
Determining the yield curve
The par yield for a certain maturity is the
coupon rate that causes the bond price to The yield curve is the graphical representation
equal its face value. of the zero rate R(T) plotted as a function of
In our example we solve maturity
The yield curve can be determined from prices
of bonds with several maturities, using a
method called bootstrapping

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Example: Data to Determine Zero Curve (Table The Bootstrap Method

4.3, page 86)

An amount 0.4 can be earned on 99.6 during

Bond Principal Time to Coupon per Bond price ($) 3 months.
Maturity (yrs) year ($)*
100 0.25 0 99.6
Because 100=99.4e0.01603×0.25 the 3-month rate
100 0.50 0 99.0
is 1.603% with continuous compounding
100 1.00 0 97.8 Similarly the 6 month and 1 year rates are
100 1.50 4 102.5 2.010% and 2.225% with continuous
100 2.00 5 105.0 compounding

* Half the stated coupon is paid each year

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The Bootstrap Method continued Zero Curve Calculated from the Data
(Figure 4.1, page 87)

To calculate the 1.5 year rate we solve

to get R = 0.02284 or 2.284%

Similarly the two-year rate is 2.416%

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Forward Rates Formula for Forward Rates

Suppose that the zero rates for time periods T1 and T2
are R1 and R2 with both rates continuously
Definition: The forward rate is the future zero compounded.
rate implied by today’s term structure of interest The forward rate for the period between times T1 and
rates T2 is

This formula is only approximately true when rates are

not expressed with continuous compounding

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Application of the Formula Bonds: Duration and convexity

Year (n) Zero rate for n-year Forward rate for nth
The sensitivity of the bond price to changes in
investment year the yield curve is measured by duration and
(% per annum) (% per annum)
convexity
1 3.0
2 4.0 5.0 Duration: the slope of the price vs shift of yield
3 4.6 5.8 curve
4 5.0 6.2 Convexity: the curvature of the price vs shift of
5 5.5 6.5
yield curve

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Duration (page 94-97) Convexity

Duration of a bond that provides cash flow ci The convexity, C, of a bond is defined as
at time ti is

This leads to a more accurate relationship

where B is its price and y is its yield
(continuously compounded)
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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Duration and Bond Price change Bond Portfolios

Duration offers a simple (approximate) formula for the change in the The duration for a bond portfolio is the weighted
price of the bond for a given change in yield. average duration of the bonds in the portfolio with
weights proportional to prices
Under this approximation, bond price changes are linear in yield
changes The key duration relationship for a bond portfolio
describes the effect of small parallel shifts in the yield
curve
What exposures remain if duration of a portfolio of
assets equals the duration of a portfolio of liabilities?

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Forward Rate Agreement Forward Rate Agreement: Key Results

A forward rate agreement (FRA) is an OTC An FRA is equivalent to an agreement where interest at
agreement that a certain rate will apply to a a predetermined rate, RK is exchanged for interest at
certain principal during a certain future time the market rate
period - Simplest IR derivative An FRA can be valued by assuming that the forward
interest rate, RF , is certain to be realized
R(T1,T2) Receive R(T1,T2) This means that the value of an FRA is the present
value of the difference between the interest that would
be paid at interest at rate RF and the interest that would
t=0 (today) T1 T2 Pay fixed rate K be paid at rate RK

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