Options, Futures, and Other Derivatives

Eleventh Edition

Chapter 4
Interest Rates

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Bonds (Debts) ---- Coupon( Interest) + FV ( Face Value). you are transferring consumption hence you want to be compensated for the loss of
purchasing power due to inflation. While calculating Interest rates consider the no. of days, especially in swaps we need to do that. In swaps we will
use SIMPLE Interest.

Types of Rates
Three types. T-bills, T notes and T bonds. All are bonds. Interest rates are padi
semi annually
• Treasury rates T-bills = Maturity <= 1 year. Zero coupon bonds.
T Notes = Maturity (1-10 years)
T bonds = Maturity > 10 years
• Overnight rates Also called Feds Fund rate. Unsecured Loans. will pay back in a day with interest. If
multiple borrowings interest calculated with weighted average rate.

• Repo rates Repurchase rates. Secured Loans. It is a rate at which you can repurchase your collateral.
$100 mn $100 mn

• LIBOR collateral = Treasury of A Collateral = Treasury of A

Therefore Total debt = 200 million but security is 100 million

London Interbank offer rate. Can be manipulated hence SOFR is used

SOFR = Secured Overnight funding rate. collateral is usually treasury. Used now in US denominated. Very clsoe to
risk free rate. hence over night rates will be considered risk free rate.

Homework = Explain what is repo 105

1 basis point = 0.01%

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Treasury Rate
• Rate on instrument issued by a government in its own
currency

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Overnight Rates
• Unsecured borrowing and lending between banks as they
adjust the reserve requirements they are required to keep
with the central bank.
• Referred to as the Fed Funds Rate in the U.S.
• The effective fed funds rate is the weighted average of
the rates on brokered transactions.
• Central bank may intervene with its own transactions to
raise or lower the overnight rate.

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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.

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LIBOR
• LIBOR is the rate of interest at which a AA-rated bank
estimates it can borrow money on an unsecured basis
from another bank at 11am.
• Several currencies and maturities
• Regulators planned to phase out LIBOR by the end of
2021 and replace it with rates based on transactions
observed in the overnight market.
• The new reference rates (e.g., for a 3-month period) will
be calculated at the end of the period as the compounded
overnight rates for that period.

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The New Reference Rates (1 of 2)
• US dollar: SOFR (secured overnight funding rate)
• GBP: SONIA (sterling overnight index average)
• EU: ESTER (euro short-term rate)
• Switzerland: SARON (Swiss average overnight rate)
• Japan: TONAR (Tokyo average overnight rate)

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The New Reference Rates (2 of 2)
• SOFR is calculated from repos and is therefore a
secured rate.
• The others are calculated from unsecured overnight
borrowing and lending between banks.

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The Risk-Free Rate
• The Treasury rate is considered to be artificially low
because:
– Banks are not required to keep capital for Treasury
instruments.
– Treasury instruments are given favorable tax treatment
in the U.S. .

You have to pay federal taxes but no state taxes on your treasury interest income.

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Impact of Compounding (Table 4.1)
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
Semiannual (m = 2) 110.25 Nominal Rate = 10 % EAR = 10.25%
( 110.25-100/100*100)

Quarterly (m = 4) 110.38 EAR = ( 1+R/m)^m-1

Monthly (m = 12) 110.47
Weekly (m = 52) 110.51
Daily (m = 365) 110.52
100(1+0.1/365)^365

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A*e^rt = r = rate of Interest is annual, t = no. of years. We will always do continuous compounding and
discounting coz they will be used in black shoels model later.
Compounding = A*e^rt.
Discounting = A*e^-rt S0*e^rt

Continuous Compounding (Equation 4.2)

• In the limit as we compound more and more frequently,
we obtain continuously compounded interest rates.

• $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

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Conversion Formulas (Equations 4.3 and 4.4)
Define
Rc : continuously compounded rate
Rm : same rate with compounding m times per year

 Rm 
Rc  m ln  1   Formula derived as per page 83. Keep
 m  this Formula in Mind


Rm  m e Rc / m  1 

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Examples
• 10% with semiannual compounding is equivalent to
2 ln(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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Zero Rates
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. Invest Investment + return

Rate of return during the period = Zero hence Zero rate as there is no
income in between.

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Example (Table 4.2)

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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Bond Pricing or Bond Market Price

• 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:

3e 0.050.5  3e 0.0581.0  3e 0.0641.5

 103e 0.0682.0  98.39

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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.
• 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%.

r = calculate using Goal seek in [Link] is yield to maturity.
Use financial calculator PMT = 3, FV = 100, PV = -98.39, N = 6 I/Y =3.379 Final I/Y = 3.379 *2 = 6.76%

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 Par yield is the coupon rate at which the Bond price is selling at Face value.
When Price of bond = Face value then bond is selling at par.

Par Yield (1 of 2)
Par yield = coupon rate when bond is selling at par.
When bond is selling at par coupon rate = yield to maturity.
Par yield = YTM as bond is selling at maturity.
Same as calculating YTM when bond is selling at par
Par Yield = Coupon rate = YTM

• 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

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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Data to Determine Zero Curve (Table 4.3)

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 every six months

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The Bootstrap Method (1 of 2) Refer Notebook for sums solved

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

• Because 100  99.4e0.01603  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 (2 of 2)
• 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
(Figure 4.1)
Graph is useful to get the data for months we dont have zero rate eg. 9 months

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

Standing at time zero I want to find out the rate I will earn till time 3 if I invest at time 2, I am still standing at T =0. This is not
derivative forward rate.

X*e^0.05(1) *e^r*1 = X*e^0.06*2

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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 T 1 a n d T 2 is

R2 T2  R1 T1
R3 =
T2  T1

• This formula is only approximately true when rates

are not expressed with continuous compounding.

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Application of the Formula (Table 4.5)

Year (n) Zero rate for n-year Forward rate for nth
investment year
(% per annum) (% per annum)
Blank

1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5

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Why calculate Forward Rate ?? == for forward rate agreement

Forward Rate Agreement

SOFAR = RK

• A forward rate agreement (FRA) is an OTC

agreement that the actual rate applicable to a certain
period will be exchanged for a predetermined rate, Fixed Rate = RF
RK , with both being applied to a predetermined principal.
When you enter into a forward rate agreement the value of the contract or the payoff is
zero. they will enter only if the pay off in the future looks zero on T0. As you progress the
value of FRA changes.

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Forward Rate Agreement: Key Results
• An FRA can be valued by assuming that the forward
interest rate, RF , is certain to be realized.

• 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
be paid at rate RK

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Example
• An FRA entered into some time ago states that a
company will receive 5.8% (s.a.) and pay SOFR on
a principal of $100 million starting in 1.5 years.
• Forward SOFR for the period between 1.5 and 2
years is 5% (s.a.)
• The 2 year (SOFR) risk-free rate is 4% with
continuous compounding.
• The value of the FRA (in $ millions) is

100  (0.058  0.050)  0.5  e 0.04  2  0.3692

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Duration (Equation 4.8) Important concept

• Duration of a bond that provides cash flow ci

at time t i is

 ci e  yti 
n
D   ti  
B = Bond Price
y = YTM / Rate /R
i 1  B  ti= No of terms/years

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

compounded).
Duration is a measure of how long a bond holder has to wait before getting his or her
investment back.

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Key Duration Relationship (1 of 2)
• 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
 Dy Important formula.

If the YTM changes by Delta Y we can calculate how much the bond price changes. Delta B is
the change in bond price corresponding to delta Y change to YTM.
When YTM increases Price goes down and vice versa.

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Key Duration Relationship (2 of 2)
• When the yield y is expressed with compounding m
times per year

BDy
B  
1 y m

• The expression
D
1 y m

is referred to as the “modified duration.”

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