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    Basic Yield Curve Mathematics: T T T T

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    VIVEK SHARMA
    The document discusses yield curve mathematics. It defines the term structure of interest rates as the relationship between the yield-to-maturity of a zero-coupon bond and the bond's maturity. It states that it is common to use continuously compounded rates when pricing derivatives modeled in continuous time. The price of a zero-coupon bond that pays 1 unit of currency at time t is denoted as Z(0,t). If Z(0,t1) < Z(0,t2) for t1 < t2, an arbitrage opportunity exists. While such zero-coupon bonds do not always trade directly, their prices can be implied through a process called bootstrapping using available market data.

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    Basic Yield Curve Mathematics: T T T T

    Uploaded by

    VIVEK SHARMA
    37 views1 page
    The document discusses yield curve mathematics. It defines the term structure of interest rates as the relationship between the yield-to-maturity of a zero-coupon bond and the bond's maturity. It states that it is common to use continuously compounded rates when pricing derivatives modeled in continuous time. The price of a zero-coupon bond that pays 1 unit of currency at time t is denoted as Z(0,t). If Z(0,t1) < Z(0,t2) for t1 < t2, an arbitrage opportunity exists. While such zero-coupon bonds do not always trade directly, their prices can be implied through a process called bootstrapping using available market data.

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    The document discusses yield curve mathematics. It defines the term structure of interest rates as the relationship between the yield-to-maturity of a zero-coupon bond and the bond's maturity. It states that it is common to use continuously compounded rates when pricing derivatives modeled in continuous time. The price of a zero-coupon bond that pays 1 unit of currency at time t is denoted as Z(0,t). If Z(0,t1) < Z(0,t2) for t1 < t2, an arbitrage opportunity exists. While such zero-coupon bonds do not always trade directly, their prices can be implied through a process called bootstrapping using available market data.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    37 views1 page

    Basic Yield Curve Mathematics: T T T T

    Uploaded by

    VIVEK SHARMA
    The document discusses yield curve mathematics. It defines the term structure of interest rates as the relationship between the yield-to-maturity of a zero-coupon bond and the bond's maturity. It states that it is common to use continuously compounded rates when pricing derivatives modeled in continuous time. The price of a zero-coupon bond that pays 1 unit of currency at time t is denoted as Z(0,t). If Z(0,t1) < Z(0,t2) for t1 < t2, an arbitrage opportunity exists. While such zero-coupon bonds do not always trade directly, their prices can be implied through a process called bootstrapping using available market data.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
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    Basic Yield Curve Mathematics

    Much of what is said here is a reprise of the excellent introduction in


    [Rebonato, 1998, 1.2].
    The term structure of interest rates is defined as the relationship between
    the yield-to-maturity on a zero coupon bond and the bonds maturity.
    If we are going to price derivatives which have been modelled in
    continuous-time off of the curve, it makes sense to commit ourselves to
    using continuously-compounded rates from the outset.
    Now is denoted time 0. The price of an instrument which pays 1 unit of
    currency at time tsuch an instrument is called a discount or zero coupon
    bondis denoted Z(0, t). The inverse of this amount could be denoted
    C(0, t) and called the capitalisation factor: it is the redemption amount
    earned at time t from an investment at time 0 of 1 unit of currency in said
    zero coupon bonds. The first and most obvious fact is that Z(0, t) is decreasing
    in t (equivalently, C(0, t) is increasing). Suppose Z(0,t1) < Z(0,t2) for some
    t1 < t2. Then the arbitrageur will buy a zero coupon bond for time t1, and
    sell one for time t2, for an immediate income of Z(0,t2)Z(0,t1) > 0. At time t1
    they will receive 1 unit of currency from the bond they have bought, which
    they could keep under their bed for all we care until time t2, when they deliver
    1 in the bond they have sold.
    What we have said so far assumes that such bonds do trade, with sufficient
    liquidity, and as a continuum i.e. a zero coupon bond exists for
    every redemption date t. In fact, such bonds rarely trade in the market.
    Rather what we need to do is impute such a continuum via a process
    known as bootstrapping.
    It is more common for the market practitioner to think and work in
    terms of continuously compounded rates. The time 0 continuously compounded
    risk free rate for maturity t, denoted r(t), is given by the relationship
    C(0, t) = exp(r(t)t) (1)
    Z(0, t) = exp(r(t)t) (2)
    r(t) = 1
    t
    ln Z(0, t) (3)

    In so-called normal markets, yie

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