DTU409E
Chapter 5: Interest rate
and forward rate agreement
Instructor: Nguyen Huy Hieu
Department of Corporate Finance
Faculty of Banking and Finance
Foreign Trade University
Email: hieunh@[Link]
Chapter 5: Interest rate
1. Interest rate: The amount of money a borrower promises to pay the lender. The interest
rate applicable in a situation depends on the credit risk. The higher the credit risk, the higher the
interest rate that is promised by the borrower.
Types of rates
• Treasury rates: The rates an investor earns on Treasury bills and Treasury bonds,
instruments used by a government to borrow in its own currency.
It is usually assumed that there is no chance that a government will default on an obligation
denominated in its own currency =>> It is usually regarded as risk – free rate.
Chapter 5: Interest rate
1. Interest rate:
LIBOR (London Interbank Offerred Rate): Unsecured short – term borrowing rate between
banks. In history, LIBOR had been manipulated by traders (Tom Hayes).
LIBOR now is a less – than – idea reference rate for derivatives transactions because it is
determined from estimates made by banks, not from market transactions.
It is likely that the derivatives market will move to using other reference rates in the future.
What is LIBOR and how is it important?
Chapter 5: Interest rate
1. Interest rate:
Overnight rate
Banks are required to maintain a certain amount of cash (reserve) with the central bank. The
reserve requirement for a bank at any time depends on its outstanding assets and liabilities.
At the end of the day, some financial institutions typically have surplus funds in their accounts
with the central bank while other have requirements for funds. This lead to borrowing and lending
overnight. A broker usually matches borrowers and lenders.
In the US, the central bank is the Federal Reserve (Fed). The overnight rate is called the federal
funds rate (Fed fund rate). This overnight rate is monitored by the Federal Serve.
This rate is monitored by the Federal Reserve, which may intervene with its own transactions
in an attempt to raise or lower it.
In Vietnam, which rate might be used as the same function?
Chapter 5: Interest rate
1. Interest rate:
Repo rates
Repo rates are secured borrowing rates. In a repo (or repurchase agreement), a financial
institutiton that owns securities agrees to sell the securities for a certain price and buy them back at a
later time for a slightly higher price.
The financial institution is obtaining a loan and the interest it pays is the difference between
the price at which the securities are sold and the price at which they are repurchased. We refer this
that to as a repo rate.
If structured carefully, a repo 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 provided by the lending
company.
The most common type of repo is an overnight repo, which may be rolled over day to day.
Because it is a secured rate, a repo rate is generally slightly below the corresponding LIBOR or
Fed fund rate.
Chapter 5: Interest rate
2. Swap rates
Example: An agreement where a LIBOR interest rate is exchanged for a fixed rate of interest for
a period of time.
Overnight indexed swaps
OIS is a swap where an agreed fixed rate for a period (e.g. one month or three months) is
exchanged for the geometric average of the overnight rates during the period.
Chapter 5: Interest rate
3. The risk free rate
The risk free rate plays a central role in derivative pricing. It might be thought that derivatives
traders would use the rates on Treasury bills and Treasury bonds as risk – free rates. In fact, they do
not do this. This is because there are tax and regulatory factors that lead to Treasury rates being
artificially low. For example:
• Banks are not required to keep capital for investments in a Treasury instruments, but they are
required to keep capital for other very low risk instruments
• In the US, Treasury instruments are given favourable tax treatment compared with other very
low risk instruments because the interest earned by investors is not taxed at the the state level.
Chapter 5: Interest rate
3. The risk free rate
Chapter 5: Interest rate
4. Measuring interest rates
Continuous compounding: An amount A invested for n years at rate R grows to
AeR x n
Example 1: Consider an interest rate that is quoted as 10% per annum with semiannual compounding.
The equivalent rate with continuous compounding is
!.#
2 ln(1 + ) = 0.09758 or 9.758%/annum.
$
Example 2: Suppose that a lender quotes the interest rate on loans as 8% per annum with continuous
compounding, and that interest is actually paid quarterly.
With m = 4 and Rc = 0l08, the equivalent rate with quarterly compounding is:
4 x (e 0.08/4 – 1) = 0.0808 or 8.08%/ annum
Chapter 5: Interest rate
5. Zero rate
The n – year zero – coupon interest rates is the rate of interest earned on an investment that starts today
and last for n – years.
All the interests and principal is realized at the end of n years, and there are no intermediate payments.
The n – year zero – coupon interest rate is sometimes also referred to as the n – year spot rate, the n –
year zero rate or just the n – year zero.
Example: Suppose a 5 – year zero rate with continuous compounding is quoted as 5%/annum. This
means that $100, if invested for 5 years, grows to:
100 x e0.05 x 5 = 128.40
Most of the interests we observe directly in the market are not pure zero rates. Consider a 5 – year risk –
free bond that provides a 6% coupon. The price of this bond does not by itself determine the 5 – year risk – free
zero rate because some of the return on the bond is realized in the form of coupons prior to the end of year 5.
Chapter 5: Interest rate
6. Bond pricing
Most bonds pay coupons to the holder periodically. The bond’s principal (which is also known as its par
value or face value) is paid at the end of its life. The theoretical price of a bond can be calculcated as the present
value of all the cash flow that will be received by the owner of the [Link], bond traders use the same
discount rate for all the CF underlying a bond, but a more accurate approach is to use a different zero rate for
each CF.
Chapter 5: Interest rate
6. Bond pricing
Example
Suppose that a 2 – year bond with a principal of $100
provides coupons at the rate of 6% per annum semiannually.
The theoretical price of the bond is:
3 e- 0.05 x 0.5 + 3e- 0.058 x 1 + 3e-0.064 x 1.5 + 103 e-0.068 x 2.0 = $98.39
Bond yield: The single discount rate that, when applied to all CF, gives a bond price equal to its
market price.
Example: Suppose that the bond above have market value of $98.39, and we call y as the yield of the
bond (expressed with continuous compounding):
3 e- y x 0.5 + 3e- y x 1 + 3e- y x 1.5 + 103 e- y x 2.0 = $98.39, which give y = 6.76%
Chapter 5: Interest rate
6. Bond pricing
Par yield for a certain bond maturity is the coupon rate that causes the bond price to equal its
par value.
Example: Suppose that the coupon on a 2 - year bond is c per annum. The value of the bond is
equal to its par value of 100 when
! - 0.05 x 0.5 ! ! !
e + e- 0.058 x 1 + e- 0.064 x 1.5 + (100 + ) e- 0.068 x 2.0 = $100
" " " "
Which give c = 6.87 or coupon rate = 6.87%.
Chapter 5: Interest rate
7. Determining zero rates
Zero rates can be calculated via 2 methods
• Stripped yield
• Bootstraping
Table 4.3 provides the prices of 5 bonds. The first 3 bonds pay no coupons, the zero rates
corresponding to the maturities of these bonds can be calculated. The continuously compounded 3
month rate R given by solving: 100 = 99.6 x eR x 0.25 => R = 1.63% per annum.
The 6 month continuously compounded rate R given by solving: 100 = 99 x eR x 0.5 => R = 2.010% per
annum.
The 1 year compound rate R given by solving: 100 = 97.9 x eR x 1.0 => R = 2.225% per annum.
Chapter 5: Interest rate
7. Determining zero rates
Treasury rates: Can be calculated from Treasury bills and Treasury bond prices.
Example: Table 4.3 provides the prices of 5 bonds. The first 3 bonds pay no coupons, the zero rates
corresponding to the maturities of these bonds can be calculated.
The continuously compounded 3 month rate R given by solving: 100 = 99.6 x eR x 0.25 => R = 1.63%/annum.
The 6 month continuously compounded rate R given by solving: 100 = 99 x eR x 0.5 => R = 2.010%/annum.
The 1 year compound rate R given by solving: 100 = 97.9 x eR x 1.0 => R = 2.225%/annum.
Chapter 5: Interest rate
7. Determining zero rates
The fourth bond lasts 1.5 years. The cash flow it provides are as follows:
6 months: $2
1 year: $2
1.5 years: $102
Suppose the 1.5 year zero rate is denoted by R. It follows that
2 x e- 0.02010 x 0.5 + 2 x e-0.02225 x 1.0 + 102 x e-R x 1.5 = 102.5
given R = 0.002284.
Chapter 5: Interest rate
7. Determining zero rates
This method is called bootstrapping
The rates that are calculated via this method are
summarized in Table above.
A chart showing the zero rate as a function of maturity
is known as the zero curve.
A zero curve is a special type of yield curve that maps interest rates on zero-coupon bonds to
different maturities across time. Zero-coupon bonds have a single payment at maturity, so these curves
enable you to price arbitrary cash flows, fixed-income instruments, and derivatives.
Zero curves are separately constructed for government securities and for inter-bank markets.
Chapter 5: Interest rate
7. Determining zero rates
Example: Vietnam yield curve given by HNX
Chapter 5: Interest rate
7. Determining zero rates
In practice, we do not usually have bonds with maturities equal to exactly 1.5 years, 2 years or
2.5 years. One approach is to linearly interpolate between the bond price data before it is used to
calculate the zero rate.
A more sophisticated approach is to use polynomial or exponential functions, rather than
linear functions for the zero curve between times ti and ti + 1 for all i.
Chapter 5: Interest rate
8. Forward rates
Forward interest rates: Rates of interest implied by current zero rates for periods of time in
the future. Example: Table below show the zero rates for various maturity (The rates are assumed to
be continuously compounded).
Chapter 5: Interest rate
8. Forward rates
In general, if R1 and R2 are the zero rates for maturities T1 and T2, respectively, and RF is the
forward interest rate for the period of time between T1 and T2, then
$! %! ' $" %" $! ' $"
𝑅# = , or 𝑅# = 𝑅" + 𝑇(
%! ' %" %! ' %"
It shows that, if the zero curve is upward sloping between T1 and T2, so that R2 > R1 and vice versa.
)$
Besides, taking limits as T2 approaches T1, we have: 𝑅# = 𝑅 + 𝑇 , where R is the zero rate for a
)%
maturity of T. This value of RF is known as the instantaneous forward rate for a maturity of T, and being
appicable to a very short future tume period that begins at time T.
Chapter 5: Interest rate
Chapter 5: Interest rate
8. Forward rates
If a large financial institution can borrow or lend at the rates above, it can lock in the forward rate.
If they thinks that rates in the future will be different from today’s forward rates, there are many
trading strategies that the investors will find attractive. One of these involves enterning into a contract
known as a forward rate agreement (FRA).
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
FRA is an OTC contract designed to fix the interest rate that will apply to either borrowing or
lending a certain principal amount during a specified future time period.
When an FRA is first negotiated, the specified interest rate usually equals the forward rate.
The contract then has value of 0.
Most FRAs are based on LIBOR. A trader who will borrow a certain principal amount at LIBOR
for a future period can enter into an FRA where for the specified time period LIBOR will received and a
predetermined fixed rate will be paid on a principal amount.
The main purpose of FRA is to convert the uncertain floating LIBOR rate to a fixed rate.
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
In general, suppose X has agreed to lend money at LIBOR to company Y for the period of time
between T1 and T2, and enters into an FRA to fix the rate of interest it will receive.
RK: The rate of interest agreed to in the FRA
RF: The forward LIBOR interest rate for the period between T1 and T2 calculated today.
RM: The actual LIBOR interest rate observed in the market at time T1 for the time period
between times T1 and T2
L: The principal underlying the contract.
Rates RK, RF and RM are all measured with a compounding frequency reflecting the length of
the period they apply to.
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
Normally company X would earn RM from the LIBOR loan. Under the FRA, it will earn RK
The extra interest rate therefore leads to a cash flow to company X at time T2 of
L (RK - RM) (T2 – T1)
FRAs are usually settled at time T1 rather than T2. The payoff must then be discounted from
time T2 to T1. The discount rate should be the risk – free rate at time T1 for the period between T1 and
T2.
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
Example
Suppose that a company enters into an FRA that is designed to ensure it will receive a fixed rate of
4% on a principal of $100m for a 3 month period starting in 3 years.
The FRA is an exchange where LIBOR is paid and 4% is received for the 3 month period. If 3 month
LIBOR proves to be 4.5% for the 3 – month period, the cash flow to the lender will be
100,000,000 x (0.04 – 0.045) x 0.25 = -$125,000, at the 3.25 – year point.
The cash flow to the party on the opposite side of the transaction will be +$125,000 at that time. In
practice, the contract is settle at the beginning of the period by a payment of the present value of the
payoff. (ie. Risk free rate is 5% - compound continuously).
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
FRA valuation
Why we need to value FRA?
It is always worth zero when FRA is desgined so that RK = RF at time 0. As time passes, RK
remains the same but RF is likely to change. The contract therefore no longer has a value of 0.
We compare two FRAs, in which the realized LIBOR, RM, is paid.
1. 1st FRA promises that the current LIBOR forward rate will be received on a principal of L between
times T1 and T2
2. 2nd FRA promises that RK will be received on the same principal between the same two dates.
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
FRA valuation
The two contracts are the same except for the interest payments received at time T2.
The difference is therefore:
L (RK – RF) (T2 – T1) e – R2T2
Because the value of the 1st FRA is 0, the value of the 2nd FRA is exactly this difference.
We can see that an FRA can be valued if we
• Calculate the payoff on the assumption that forward rates are realized
• Discount this payoff at the risk – free rate
Chapter 5: Interest rate
9. Forward rate agreement (FRA)
FRA valuation
Example: Suppose that the forward LIBOR rate for the period between time 1.5 years and time
2 years in the future is 5% (with semiannual compounding) and that some time ago, a company
entered into an FRA where it will receive 5.8% (with semi-annual compounding) and pay LIBOR on a
principal of $100m for the period.
The 2 year risk – free rate is 4% (continuous compounding).
The value of FRA is:
100,000,000 x (0.058 – 0.050) x 0.5 e -0.04 x 2 = $369,200
Chapter 5: Interest rate
10. Duration/ Modified duration.
11. Convexity.
Thank you !!!