Topic 2: Interest Rates

Willem J. van Vliet

FINA4110 Options and Futures

Chinese University of Hong Kong

2025 Term 1

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Interest Rates and This Class

Understanding and being uent with interest rates is crucial for

doing well in this course.

I can't stress this enough: if you are not already super comfortable
computing interest payments and converting interest rates from one
compounding convention to another, you will have a tough time,
especially with swaps!

Take the time to learn it now so you won't struggle later.

As much of this is review, I will go very fast, but please ask questions
if you have any!

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What You Should Learn

1 Understand how interest rates are expressed, and what the interest
payments are.

2 Change between compounding frequencies.

3 Discounting.

4 Forward rates.

5 Basic understanding of sources of interest rates.

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Interest Rates

Generally speaking, an interest rate is the amount of interest owed in

a specied time period relative to the principal. That is

interest payment in one period

R=
principal amount

Interest rates often quoted in percentages (1% = 0.01), and

sometimes in basis points (1bp = 0.01% = 0.0001)

For example, if you borrow $1,000,000 and owe an interest payment of

$30,000 in 1 year, then the interest rate per year is

30, 000
R= = 0.03 = 3%
1, 000, 000

Interest rates are usually expressed pear year. A fancy way to say this
is per annum, often abbreviated p.a., which simply means per year
in Latin.

In the example above, the interest rate is 3% per annum

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Pro-Rata Interest

Interest rates are usually expressed per year, even when the payment
period is shorter

For example, you could have a 3-month loan with a 10% p.a. interest
rate

In this case, the interest rate is calculated pro rata (pro-rated):

length of payment period

interest payment = principal × interest rate ×
length of one year

So, in the 3-month loan example above, the interest payment (on a
$1,000,000 principal) is

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$1, 000, 000 × 0.03 × = $7, 500
12

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Day-Count Conventions

In this class, we will not bother with day-count conventions and

things like leap years! We will keep things very simple.

one day 1 one month 1 one quarter 1

= = =
one year 365 one year 12 one year 4

In real life, things are much more complicated. Contracts come with a
day-count convention to tell you how pro-rating is done. These can be
incredibly sneaky!

Example: 30/360 convention (one month counts as 30 days, one

year is 360 days). How much interest is paid from February 28 to
March 1?
▶ Except for versions of 30/360 that specically have a clause to handle

February, you would get 3 days' worth of interest!

▶ How? February to March is 30 days. Then 1 is 27 days earlier than 28,

so that is -27 days. Combine them for 30 − 27 = 3 days.

▶ This means that you would get paid

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principal × interest rate ×
360 6
Compounding

Compounding refers to interest being paid on interest

You've all seen this before

If you start with A dollars invested at an interest rate of R per annum

compounded annually for n years, at the end you will have a total of

$A × (1 + R)n

at the end of n years

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Compounding Frequency

This combines the pro-rating and compounding you have learned.

Let's start with an easy example: invest $1,000 at an interest rate of

4% per annum compounded semiannually (twice a year) for one whole
year
▶ Start with a balance of $1,000
▶ First interest payment is after rst half of a year. 4% per year for half a
1
year means a payment of 4% × 2 = 2%. So after half a year, your
balance is

$1, 000 + $1, 000 × 2% = $1, 000 × (1 + 2%) = $1, 020

1
▶ After one full year, you earn a payment of 4 %× 2 = 2% over this new
balance of $1,020 for a total of

$1, 020 + $1, 020 × 2% = $1, 020 × (1 + 2%) = $1, 040.40

▶ We can calculate this in one go:

 2
4%
$1, 000 × 1 + = $1, 040.40
2

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Compounding Frequency

In general, if the interest rate is R per annum, compounded k times

per year, then if you start with A dollars it grows to

R n
 
$A × 1 +
k

after n compounding periods (not years!)

So, for example, if you invest $100 at 6% per year compounded

quarterly (four times per year) for three years:
▶ 3 × 4 = 12 compounding periods (three years, four times per year)
▶ Get a total of
 12
6%
$100 × 1 + ≈ $119.56
4

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Common Source of Confusion

If the compounding periods are longer than the payment period, the
compounding frequency doesn't matter

Example: you invest $1,000 for 3 months at 4% per annum:

1
$1, 000 × 4% × = $10
|{z} 4
annual rate
|{z}
pro-rating 3 months of one year

$1,000 for 3 months at 4% p.a. with quarterly compounding:

4%
$1, 000 × × 1 = $10
4 |{z}
|{z} one quarter
one fourth of annual rate per quarter

$1,000 for 3 months at 4% p.a. with semiannual compounding:

4% 1
$1, 000× × = $10
2 2
|{z} |{z}
one half of annual rate per half year pro-rating 3 months of half a year

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Compounding Frequency

Consider what happens to $A invested at an interest rate of R per

annum compounded k times per year for one year. It grows to
 k
R
$A × 1 +
k
You should convince yourself that this quantity is increasing in k
(when R > 0):
▶ Intuition: compounding means you get interest paid on interest, so

with higher compounding frequency k, you get more interest paid out
on interest

Example: $1,000 invested at R = 4% per annum (with dierent

compounding frequencies) after one year:
▶ Annual compounding: $1, 000 × (1 + 4%) = $1, 040
 2
4%
▶ Semiannual compounding: $1, 000 × 1 + = $1, 040.40
2
 4
4%
▶ Quarterly compounding: $1, 000 × 1 + = $1, 040.60
4
 365
4%
▶ Daily compounding: $1, 000 × 1 + = $1, 040.81
365
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Continuous Compounding

What happens when we compound innitely frequently:

 k
R
lim 1 + = eR
k→∞ k

Innite compounding frequency is known as continuous

compounding

Often, continuously compounded interest rates are denoted by

lowercase r

$A invested at an interest rate of r per annum with continuous

compounding grows to
$A × e rt
after t years

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Quick Digression on Notation

I will denote the exponential function in dierent ways depending on

what is more convenient:

e x = exp(x) = exp{x}
All three things mean the same thing

Logarithms in this class will always be the inverse of the

exponential. That is, all logarithms are natural logarithms.

I use
log x
to denote the inverse of the exponential. On calculators this may be
written as:
ln x or loge x

Do not use a base-10 or base-2 logarithm. Calculators sometimes have

a button log which means log10 . Make sure you do not use that one.
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Converting

It is sometimes helpful to have interest rates expressed in dierent

ways
▶ Quantitative models typically involve continuously compounded interest

rates for discounting

▶ Interest rates often quoted with non-continuous compounding
▶ Interest payments easiest to calculate from non-continuous

compounding

When I say interest rates expressed in dierent ways what I mean is

the same interest payment, just expressed with a dierent
compounding frequency

For example: 4% p.a. with quarterly compounding is what percent

p.a. with continuous compounding?

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Converting

Method that always works:

1 Pick a time period that is a multiple of both the source and the target
compounding interval. (In this class, one year will always work.)
2 Fix a convenient principal: $1, $100, or $1000 is usually nice. I usually
pick $1.
3 Calculate how much interest is earned in the time period for the given
interest rate and compounding frequency.
4 Calculate how much interest is earned in the time period for an
unknown interest rate R (or r) at the target compounding frequency.
5 Set the results from 3. and 4. equal, and solve for R.

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Example

What is 6% per annum with monthly compounding expressed as an

interest rate per annum with annual compounding?

In one year, $1 at 6% p.a. with monthly compounding grows to

 12
0.06
$1 × 1 + ≈ $1.06168
12

In one year, $1 at rate R per annum (with annual compounding)

grows to
$1 × (1 + R) = $(1 + R)

Setting these two equal

1 + R = 1.06168 ⇒ R = 0.06168

or about 6.168% per annum (with annual compounding).

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Another Example

What is 4% per annum with quarterly compounding expressed as an

interest rate per annum with continuous compounding?

In one year, $1 at 4% p.a. with quarterly compounding grows to

 4
0.04
$1 × 1 + = $1.04060
4

In one year, $1 at rate r per annum with continuous compounding

grows to
$1 × e r = $e r

Setting these two equals

e r = 1.04060
⇒ log e r = log 1.04060
⇒ r = 0.03980
or about 3.980% per annum with continuous compounding.
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Discounting

So far, we have been accumulating interest: applying interest to a

principal known today to gure out its value at a later point in time.

We often go in the opposite direction: if you get a payout in the

future, how much is it worth today? This is known as discounting.

To do that, we simply go the other way.

Thought experiment: suppose the interest rate is r per annum with

continuous compounding. A dollars today would grow to

B = e rt A

after t years. That means that B dollars in t years corresponds to

B
A= = e −rt B
e rt
dollars today.
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Zero Rates

Discounting will require an interest rate that applies purely between

today and a specied date in the future.

This is known as an t-year zero-coupon interest rate, which is the

interest rate paid on an investment that starts today and ends in t
years, at which point all of the principal and interest is paid (there are
no intermediate payments).

Also known as the t -year spot rate, t -year zero rate, or t -year zero.

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Zero Rates from a Zero-Coupon Bond

A zero-coupon bond is a bond (debt security) with no intermediate

payments. All payments are made at the maturity.
▶ Intermediate payments are called coupons, so zero-coupon bonds are
ones without coupons.

These bonds are characterized by their maturity and their face value
(payment due at maturity).

Suppose a t -year zero coupon bond with face value F has price P.
What is the t -year zero rate?

The price is the discounted face value

P = e −rt F
Here we know P (we can see the price today), F (the face value), and
t (the maturity). We solve for r:
log(P/F )
e −rt = P/F ⇒ log(e −rt ) = log(P/F ) ⇒ r =−
t
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Example

A two-year zero-coupon bond with face value $100 sells for $97. What
is the two-year zero rate?

We plug it in:

log(P/F ) log(97/100)
r =− =− = 0.01523
t 2

or about 1.523% per annum with continuous compounding

We can use this to discount values from two years to today. For
example, if you are promised $1500 in two years, the present value is

PV = e −0.01523×2 × $1500 = $1455

(And yes, if you really are observant, that is 97/100 × $1500.)

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Forward Rates

Zero rates are used to accumulate the value of money today to a

single future period, or to discount money from a single future period
to today.

We will sometimes need to accumulate/discount between two future

periods. To do that, we use forward rates.

The forward rate between times t1 and t2 is the interest rate that
you can lock in today between two future times t1 and t2 .

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Calculating Forward Rates

Some notation:
▶ Time 0 is denotes today
▶ The (closer) time is t1 , which is t1 units of time from today
▶ The (farther) time is t2 > t1 ,which is t2 units of time from today
▶ The t1 zero rate is r1 , which is expressed with continuous compounding
▶ The t2 zero rate is r2 , which is expressed with continuous compounding
▶ The forward rate between t1 and t2 is rF , also expressed with
continuous compounding

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Calculating Forward Rates

You should be indierent between:

▶ Investing at the long-term zero rate r2

$1 −→ $e r2 t2

▶ Investing at the short-term zero r1 , then rolling over at the forward rate
rF
$1 −→ $e r1 t1 −→ $e rF (t2 −t1 ) e r1 t1
Both are risk-free ways of moving money to t2 , so indierence means
either way we should get the same amount:

e r2 t2 = e r1 t1 e rF (t2 −t1 )

Solve for rF (take logs)

r2 t2 − r1 t1
rF =
t2 − t1

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Calculating Forward Rates

Our formula is
r2 t2 − r1 t1
rF =
t2 − t1
Note that all three interest rates here are expressed with continuous
compounding. To use this formula, you must make sure to convert r2
and r1 into continuously compounded rates rst.

There are formulas for other compounding frequencies, but they are
messy. See the note on Blackboard if you really want to know. You
are free to use those, but you have to know what you are doing.

Sometimes, to make it clear, I will denote this forward rate rF as

rt1 →t2 .

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Example

The 1-year zero rate is 2% per annum (with continuous

compounding). The 3-year zero rate is 2.5% per annum (with
continuous compounding). What is the 1- to 3-year forward rate?

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Example

The 1-year zero rate is 2% per annum (with continuous

compounding). The 3-year zero rate is 2.5% per annum (with
continuous compounding). What is the 1- to 3-year forward rate?

We just plug it all in. The formula is simple to use.

0.025 × 3 − 0.02 × 1 0.075 − 0.02

rF = = = 0.0275
3−1 2

So the forward rate is 2.75% per annum with continuous compounding

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Risk-Free Zero Rates

For pricing derivatives, we want risk-free zero rates for discounting

Some ideas for where to look:

▶ Treasurys
▶ LIBOR and IBORs
▶ Federal Funds rate
▶ OIS rate

▶ SOFR

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Treasury Rates

Interest rate on debt issued by a government to borrow in its own

currency.

For many developed countries and regions, the government is assumed

never to default. These bonds are virtually risk free, which suggests
these are great sources of risk-free interest rates.

Problems:
▶ Treasurys often used to fulll regulatory requirements
▶ Treasurys often used as high-quality collateral
▶ Treasurys often have tax benets

This leads to extra demand for these assets, which raises the price.
High prices equate to low interest rates.

Not suitable for risk-free rate: Treasury rates probably lower than
risk-free rate.

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LIBOR and IBORs

LIBOR = London Inter-Bank Oered Rate

Ask a set of banks and nancial institutions

At what rate could you borrow funds, were you to do so by asking for
and then accepting interbank oers in a reasonable market size just
prior to 11 am London time?

LIBOR rate is a trimmed mean of the responses

Available at many maturities: 1 day, 1 week, 1, 2, 3, 6, and 12 months

Available in many currencies

Should reect cost of borrowing of a AA rated nancial institution

Equivalents in other countries/regions (HIBOR, SHIBOR, SIBOR,

EURIBOR, etc.)

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LIBOR is Dead

Would seem like a great source of zero rates (and historically this was
the standard), but LIBOR is now dead

Problem 1: LIBOR scandal

▶ Banks manipulated the rate for private benets
▶ This basically started the downfall of LIBOR

Problem 2: it's all survey data, not transactions

Problem 3: some credit risk priced in

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Credit Risk in LIBOR

3-Month Treasury Constant Maturity Rate

3-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar
7

4
Percent

-1
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

1990 2000 2010

Shaded areas indicate U.S. recessions Sources: Board of Governors, IBA [Link]/g/o2Z7

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Federal Funds Rate

Banks in most regions are subject to reserve requirements: required

deposits held at the central bank

In the United States, the federal funds market consists of overnight

lending from banks with excess reserves. The interest rate charged is
called the federal funds rate.

These are uncollateralized, but overnight, so these are very low-risk

loans

In other regions: HONIA (HK), SONIA (UK), ¿STR, etc.

These are only overnight. What about longer maturities?

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Overnight Indexed Swap Rates

We will learn much more about this later

Overnight indexed swaps work as follows:

▶ Both parties make just the interest payments on some xed notional

amount
▶ One party makes payments based on an overnight rate (like federal

funds rate)
▶ Other party makes payments based on an agreed xed rate

As you will learn, this has little credit risk, and the xed rate
represents a longer-term risk-free rate
▶ But, these are not zero rates, so you will learn later how to get those

from these rates

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SOFR

US Secured Overnight Financing Rate

Overnight interest rate on secured (i.e., collateralized) lending

Calculated from transactions in the overnight Treasury repo market.

These are virtually risk-free.

Get longer maturities than overnight through swaps and futures

▶ Again, you'll learn how this works later

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