Chapter 4 Interest Rates

Short Concept Questions

4.1 LIBOR is based on estimates of the rates at which banks can
borrow, not actual transactions. As such it is open to manipulation.

4.2 In the U.S., SOFR which is a secured overnight rate, is replacing

LIBOR. Rates replacing LIBOR in other currencies such as SONIA and

ESTER are unsecured.

4.3 A repo rate is the rate implied by a transaction where it is agreed
that assets will be sold and repurchased at a slightly higher price.
4.4 See Section 4.3.

4.5 5% quarterly compounded.

4.6 See equation (4.1).
4.7 The present value is where T is the time until payment.
−RT
Ae

4.8 The par yield on a bond is the coupon rate that results in the bond's

price being equal to its par value.

4.9 An FRA is an agreement to a future exchange. A predetermined
fixed rate is exchanged for a reference rate with both being applied to
the same principal for a period of time and the interest being paid in

arrears.
4.10 Under expectations theory, long-term interest rates reflect

expected future short-term rates. Under liquidity preference theory,

they are higher than expected future short-term interest rates would

suggest.

Practice Questions
4.11 The rate with continuous compounding is

0.07
4 ln (1 + ) = 0.0694
4
or 6.94% per annum.

a. The rate with annual compounding is

4
0.07
(1 + ) − 1 = 0.0719
4

or 7.19% per annum.

4.12 Suppose the bond has a face value of $100. Its price is obtained by

discounting the cash flows at 5.2%. The price is

2 2 102
+ + = 98.29
2 3
1.026 1.026 1.026

If the 18-month zero rate is R, we must have

2 2 102
+ + = 98.29
2 3
1.025 1.025 (1 + R/2)

which gives R = 5.204% .

4.13

a. With annual compounding, the return is

1100
− 1 = 0.1
1000

or 10% per annum.

b. With semi-annual compounding, the return is R where

2
R
1000(1 + ) = 1100
2

i.e.,

R
1 + = √1.1 = 1.0488
2

so that R = 0.0976 . The percentage return is therefore 9.76%

per annum.
c. With monthly compounding, the return is R where

12
R
1000(1 + ) = 1100
12

i.e.

R
12
(1 + ) = √1.1 = 1.00797
12
 so that R = 0.0957 . The percentage return is therefore 9.57%
per annum.
d. With continuous compounding, the return is R where:

R
1000e = 1100

i.e.,

R
e = 1.1

so that R = ln 1.1 = 0.0953 . The percentage return is therefore

9.53% per annum.
4.14 The forward rates with continuous compounding are as follows,

Qtr 2 3.4%

Qtr 3 3.8%

Qtr 4 3.8%

Qtr 5 4.0%

Qtr 6 4.2%

4.15 The value of the FRA is

−0.036×1.25
1,000,000 × 0.25 × (0.045 − 0.040)e = 1, 195

or $1,195.
4.16 When the term structure is upward sloping, c > a > b . When it is

downward sloping, b > a > c .

4.17 Duration provides information about the effect of a small parallel

shift in the yield curve on the value of a bond portfolio. The percentage
decrease in the value of the portfolio equals the duration of the

portfolio multiplied by the amount by which interest rates are increased

in the small parallel shift. The duration measure has the following
limitation. It applies only to parallel shifts in the yield curve that are

small.

4.18 The rate of interest is R where:

 12
0.08
R
e = (1 + )
12

i.e.,

0.08
R = 12 ln (1 + )
12

= 0.0797

The rate of interest is therefore 7.97% per annum.

4.19 The equivalent rate of interest with quarterly compounding is

4
R
0.04
e = (1 + )
4

or

0.01
R = 4 (e − 1) = 0.0402

The amount of interest paid each quarter is therefore:

0.0402
10,000 × = 100.50
4

or $100.50.

4.20 The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30
months. The cash price is

−0.04×0.5 −0.042×1.0 −0.044×1.5 −0.046×2 −0.048×2.5

2e + 2e + 2e + 2e + 102e = 98.04

4.21 The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36
months. The bond yield is the value of y that solves

−0.5y −1.0y −1.5y −2.0y −2.5y −3.0y

4e + 4e + 4e + 4e + 4e + 104e = 104

Using the Solver or Goal Seek tool in Excel, y = 0.06407 or or 6.407%.

4.22 Using the notation in the text, m = 2 , d = e
−0.07×2
= 0.8694 . Also

−0.05×0.5 −0.06×1.0 −0.065×1.5 −0.07×2.0

A = e + e + e + e = 3.6935

The formula in the text gives the par yield as

(100 − 100 × 0.8694) × 2

= 7.0741
3.6935

To verify that this is correct, we calculate the value of a bond that pays a
coupon of 7.0741% per year (that is 3.5370 every six months). The value

is
 −0.05×0.5 −0.06×1.0 −0.065×1.5 −0.07×2.0
3.537e + 3.537e + 3.537e + 103.537e = 100

verifying that 7.0741% is the par yield.

4.23 The forward rates with continuous compounding are as follows:

Year 2: 4.0%

Year 3: 5.1%

Year 4: 5.7%
Year 5: 5.7%

4.24 Taking a long position in two of the 4% coupon bonds and a short

position in one of the 8% coupon bonds leads to the following cash

flows

Year 0 : 90 − 2 × 80 = −70

Year 10 : 200 − 100 = 100

because the coupons cancel out. $100 in 10 years time is equivalent to

$70 today. The 10-year rate, R, (continuously compounded) is therefore

given by

10 R
100 = 70e

The rate is

1 100
ln = 0.0357
10 70

or 3.57% per annum.

4.25 If long-term rates were simply a reflection of expected future

short-term rates, we would expect the term structure to be downward

sloping as often as it is upward sloping. (This is based on the

assumption that half of the time investors expect rates to increase and

half of the time investors expect rates to decrease). Liquidity preference

theory argues that long term rates are high relative to expected future
short-term rates. This means that the term structure should be upward

sloping more often than it is downward sloping.

4.26 The par yield is the yield on a coupon-bearing bond. The zero rate
is the yield on a zero-coupon bond. When the yield curve is upward

sloping, the yield on an N-year coupon-bearing bond is less than the

yield on an N-year zero-coupon bond. This is because the coupons are

discounted at a lower rate than the N-year rate and drag the yield down

below this rate. Similarly, when the yield curve is downward sloping,
the yield on an N-year coupon bearing bond is higher than the yield on
an N-year zero-coupon bond.

4.27 A repo is a contract where an investment dealer who owns

securities agrees to sell them to another company now and buy them
back later at a slightly higher price. The other company is providing a

loan to the investment dealer. This loan involves very little credit risk. If

the borrower does not honor the agreement, the lending company
simply keeps the securities. If the lending company does not keep to its

side of the agreement, the original owner of the securities keeps the

cash.
4.28

a. The bond's price is

−0.07 −0.07×2 −0.07×3 −0.07×4 −0.07×5

8e + 8e + 8e + 8e + 108e = 103.05

b. The bond's duration is

1
−0.07 −0.07×2 −0.07×3 −0.07×4 −0.07×5
[8e + 2 × 8e + 3 × 8e + 4 × 8e + 5 × 108e ]
103.05

= 4.3235 years

c. Since, with the notation in the chapter

ΔB = −BDΔy

the effect on the bond's price of a 0.2% decrease in its yield is

103.05 × 4.3235 × 0.002 = 0.89

The bond's price should increase from 103.05 to 103.94.

d. With a 6.8% yield the bond's price is

−0.068 −0.068×2 −0.068×3 −0.068×4 −0.068×5

8e + 8e + 8e + 8e + 108e = 103.95

This is close to the answer in (c).

4.29 The 6-month Treasury bill provides a return of 6/94 = 6.383% in

six months. This is 2 × 6.383 = 12.766% per annum with semiannual

compounding or 2 ln (1.06383) = 12.38% per annum with continuous

compounding. The 12-month rate is 11/89 = 12.360% with annual

compounding or ln(1.1236) = 11.65% with continuous compounding.

For the 1 year bond, we must have

1

−0.1238×0.5 −0.1165×1 −1.5R

4e + 4e + 104e = 94.84
where R is the year zero rate. It follows that
1
1
2

or 11.5%. For the 2-year bond, we must have

−0.1238×0.5 −0.1165×1 −0.115×1.5 −2R

5e + 5e + 5e + 105e = 97.12

where R is the 2-year zero rate. It follows that

or 11.3%.

4.30 The first exchange of payments is known. Each subsequent

exchange of payments is an FRA where interest at 5% is exchanged for

interest at LIBOR on a principal of $100 million. Interest rate swaps are

discussed further in Chapter 7 .

4.31 We must solve 1.11 = (1 + R/n)
n
where R is the required rate and

the number of times per year the rate is compounded. The answers are:

a) 10.71%, b) 10.57%, c) 10.48%, d) 10.45%, e) 10.44%

4.32 The bond's theoretical price is

−0.02×0.5 −0.023×1 −0.027×1.5 −0.032×2
20 × e + 20 × e + 20 × e + 1020 × e = 1015.32

The bond's yield assuming that it sells for its theoretical price is
obtained by solving
−y×0.5 −y×1 −y×1.5 −y×2
20 × e + 20 × e + 20 × e + 1020 × e = 1015.32

It is 3.18%.

4.33 (Excel file)

The answer (with continuous compounding) is 4.07%.

4.34 2.5% is paid every six months.

a. With annual compounding, the rate is
2
1.025 − 1 = 0.050625 or 5.0625%

b. With monthly compounding, the rate is

12 × (1.025
1/6
− 1) = 0.04949 or 4.949% .
 c. With continuous compounding, the rate is

2 × ln 1.025 = 0.04939 or 4.939% .

4.35 The duration of Portfolio A is

−0.1×1 −0.1×10
1 × 2000e + 10 × 6000e
= 5.95
−0.1×1 −0.1×10
2000e + 6000e

Since this is also the duration of Portfolio B, the two portfolios do have
the same duration.

a. The value of Portfolio A is

−0.1 −0.1×10
2000e + 6000e = 4016.95

When yields increase by 10 basis points, its value becomes

−0.101 −0.101×10
2000e + 6000e = 3993.18

The percentage decrease in value is

23.77 × 100
= 0.59%
4016.95

The value of Portfolio B is

−0.1×5.95
5000e = 2757.81

When yields increase by 10 basis points, its value becomes

−0.101×5.95
5000e = 2741.45

The percentage decrease in value is

16.36 × 100
= 0.59%
2757.81

The percentage changes in the values of the two portfolios for a

10 basis point increase in yields are therefore the same.

b. When yields increase by 5%, the value of Portfolio A becomes

−0.15 −0.15×10
2000e + 6000e = 3060.20

and the value of Portfolio B becomes

−0.15×5.95
5000e = 2048.15

The percentage reductions in the values of the two portfolios

are:

Portfolio A:
956.75
× 100 = 23.82
4016.95

Portfolio B: 709.66

2757.81
× 100 = 25.73
 Since the percentage decline in value of Portfolio A is less than

that of Portfolio B, Portfolio A has a greater convexity.

4.36 In the Bond Price worksheet, we input a principal of 100, a life of 2

years, a coupon rate of 6% and semiannual settlement. The yield curve

data from Table 4.2 is also input. The bond price is 98.38506. The DV01

is −0.018819 . When the term structure rates are increased to 5.01, 5.81,

6.41, and 6.81, the bond price decreases to 98.36625. This is a reduction

of 0.01881 which corresponds to the DV01. (The DV01 is actually

calculated in DerivaGem by averaging the impact of a one-basis-point

increase and a one-basis-point decrease.). The bond duration satisfies

ΔB
= −DΔy
B

In this case, ΔB = −0.01882 , B = 98.38506 , and Δy = 0.0001 so that the

duration is 10,000 × 0.01882/98.38506 = 1.91 years.

The impact of increasing all rates by 2% is to reduce the bond price by

3.691 to 94.694. The effect on price predicted by the DV01 is

200 × −0.01881 or −3.7638. The gamma is 0.036931 per % per %. In this

case, the change is 2%. From equation (4.18), the convexity correction

gamma is therefore

2
0.5 × 0.036931 × 2 = 0.0739

The price change estimated using DV01 and gamma is therefore

−3.7638 + 0.0739 = 3.690 which is very close to the actual change.

The gamma is 0.036931 per % per %. Because 1% is 0.01, gamma is

10,000 × 0.036931 . The convexity is gamma divided the bond price. This

is 10,000 × 0.036931/98.38506 = 3.75 .