001 Fi Interest Rate and Bond Calculations

Fixed Income Fundamentals
1. Interest Rate & Bond Calculations Day 1
Financial Markets Education
Interest Rates

Financial Markets Education provides instruction on all aspects
of banking and finance for UBS employees and for our top
clients.
Europe
Americas
APAC
Joe Troccolo
Joe Bonin
Onn Chan
Stamford
+ 1-203-719-6507
[email protected]
Singapore
+65-6836-5708
[email protected]
London
+44-20-7568-0735
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Walter Braegger
London
+44-20-7568-8938
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Kai-Hing Lum
Tokyo
+81-352-08-6494
[email protected]
Spencer Morris
London
+44-20-7568-8939
[email protected]
Money Market Rates

Investments of up to one year
Institutional Investors
Retail
Money Centre Banks
Banks, Thrifts, Building Societies
Financial Institutions
Brokerage sweep accounts
Retail Investors
Money Market Funds
All either have excess funds or need

funds short term
All of these take in cash deposits

Pay interest
Money Market rates are usually addon

Interest earned is calculated based on
the amount invested and added on to
it
Interest Rate Terminology

Interest Rate
Future Value
Present Value
Interest Rates are determined by:
time period
currency
credit quality
Real Cash Flows:

Money is deposited
Interest is paid
Based on the stated interest rate
Future Value / Present Value

Deposit 100 for 1 year at an interest rate of 5%
What will be the total amount after 1 year?
105
1 year
100
rate = 5%
How much needs to be deposited at 5% for 1

year so that the total amount will be 100?
100
1 year
95.24
rate = 5%
4
Spot Rate
In the example 5.00% is called the one year spot rate
One year deposit rate
One year add-on rate
One year zero rate
They all mean the same thing!
Future Value Factor / Discount Factor

Future Value of 1 = FVF
Present Value of 1 = DF (discount factor) or PVF
Depend on:
Time
Currency
Credit
e.g.
Rate for a 1-month deposit of USD10,000 in a US commercial bank
Rate for 6-month deposit of CHF50,000 in a publicly-traded Swiss money market fund
Simple Interest
Used when the time period is at most one year
No compounding (see later)
Simple formulas
FVF = 1 + rate time
1
DF = FVF
DF = 1 + rate1 time
Example : FVF = 1 + 0.05 1 = 1.05
1
DF = 1.05
= 0.9524
More Examples: Your turn

Time
Rate
6.25%
1/2
4.00%
1/4
9.00%
FVF
1.0855
1/2
1.0260
1/4
1.0150
DF
0.9100
1/2
0.9434
1/4
0.9950
8
Compounding
Rate applies to more than 1 period
period could be:
1 year
6 months
3 months
Examples:
2 year rate of 6%, compounded every 6 months
1 year rate of 8% compounded every 3 months
5 year rate of 4% compounded every year
Nominal and Effective Rates

In the previous examples the rates were nominal rates
A nominal rate of 8.00% compounded quarterly had a FVF of 1.08243
So a deposit at such a rate would actually earn 8.243% in one year
8.243% is called the effective rate
The same nominal rate could have a different effective rate depending on the
compounding period
If the 8.00% rate was compounded monthly what would the effective rate be?
10
Examples
Rate
6.00%
8.00%
4.00%
Frequency
2
4
1
Time
2
1
5
FVF
1.1255
1.0824
1.2167
PVF
0.8885
0.9238
0.8219
A Rate, Time Period and a Compounding Frequency determine a FVF and a DF

(PVF)
11
The Dreaded Formulae!
FVF = 1 +
PVF =
years frequency
rate
frequency
1
FVF
Example : FVF = 1 +
0.0600 2 2
2
= 1.1255
1
PVF = DF = 1.1255
= 0.8885
12
More Examples
6 months 7%
DF =
Frequency = 1
12 months 6%
DF =
FVF =
Frequency = 4
5 years
DF =
FVF = 1.035
9%
FVF =
Frequency = 2
13
Suppose you have the FVF?
1.0824
1
You need to specify any two of these:
Rate
Time
Compounding Frequency
Then you can determine the third!
14
Most Common Problem
1.0824
1 year
1
Compounding Frequency
Rate
8.24%
8.08%
8.00%
15
More Examples
1.19431
1.09727
Rate = _____
1
Time = 2
Rate = _____
1
Frequency = 4
Time = 1.5
Frequency = 2
1.485947
Rate = _____
1
Time = 10
Frequency = 2
16
Review: Discount Rates

Used mostly for two types of securities:
Treasury Bills
Commercial Paper
If you buy a 91 day Treasury bill with a face value of 10,000 you will receive
USD10,000 in 91 days
How much do you pay today?
17
Treasury Bill Discount Rate

10,000
91
Discount = 10,000 0.0460 360
= 116.28
Price = 10,000 - 116.28 = 9883.72
Discount Rate = 4.60%

time period = 91 days
day basis = 360
18
Homework Exercises
Nominal Rate = 10% p.a.
What are the DF and FVF for these

compounded rates:
What is the effective rate if

compounding is:
Semi-annual
_______
Rate = 12% p.a. quarterly

compounded; time = 2 years
Quarterly
_______
DF =
Monthly
_______
Daily (365)
_______
Rate = 4% p.a. monthly

compounded; time = 18 months
What is the DF and FVF for these

simple rates:
Rate
Time
DF
DF =
______
______
FVF = ______
FVF = ______
FVF
6.35%
2 months ______ ______
9.20%
6 months ______ ______
19
Exercises
What annual compounded rate
has a 3 year FVF = 1.179257?
What simple rate would have the

same 9 month DF i.e. 0.977833?
What semi-annual compounded

rate would have the same 3 year
FVF I.e. 1.179257?
A 26-week T Bill is trading at a 5%

discount. What is the price of
USD1 million of this bill?
What quarterly compounded rate

would have a 9 month DF =
0.977833?
What is its BEY?
20
Appendix
Continuously Compounded Interest
Compounding
Nominal Rate of 8.00% per annum
Compounding Frequency Effective Rate
2
8.1600%
8.2432%
12
________%
365
________%
22
The Limit
As we increase the compounding frequency the effective rate increases
But it slows down
nominal rate
frequency
8.00%
limit
1
2
4
12
365
1000
10000
effective rate 8.00000% 8.16000% 8.24322% 8.29995% 8.32776% 8.32836% 8.32867% 8.32871%
The limit is called continuous interest

It is easily calculated
rsimple t = er
continuous
23
Conversions Using Day Counts

6.00% actual/365 continuous rate
Time period 120 days
Is equivalent to what actual/365 simple rate?
Interest = e
0.06120
365
1 = 0.01992
r 120
= 0.01992
365
r = 0.0606
24
And the other way

7.25% actual / 360 rate
Time period 90 days
Is equivalent to what actual/365 continuous rate?
90
Interest = 0.0725 360
= 0.018125
90
365
90
365
1 = 0.018125
= 1.018125
90
r 365
= ln(1.01812 5) = 0.01796
r = 0.0728
25
The Yield Curves

But how do we build the curves?

The yield curve is a set of interest rates consistent with market prices for liquid
instruments
Curve
Building Tool
Market
Implied
Prices
Curve
Pricing Tool
Which can then be used to price every position
of that currency and credit quality
USD LIBOR 1998

Our curve tool for
USD LIBOR uses:
Deposit rates
Futures prices
Swaps
Government Yield Curves
Types of Interest Rates

We want to earn interest on an investment starting today, we need a spot
rate
Deposits
Bills
Commercial paper
Strips
We want to arrange today to invest at some time in the future, we want a

forward rate
Forwards
Futures
We want to receive a fixed (constant) interest payment periodically, we want

a coupon rate or par rate
Bonds
Swaps
Spot Rate Example

Short term (under one year)
Longer term
Deposit money at a bank for 9

months
A 3-year zero coupon bond is trading

for a price of 81.63
Bank quotes a rate of 6.00%
Pay 81.63 today
Get back 4.5% more
Receive 100 in 3 years

Earn an interest rate of
( ) 1 = 7.00%
100
81.63
1
3
7.00% is the 3-year annuallycompounded spot rate

Also called the 3-year zero rate
Spot Rates
FV (redemption)
Time period = t
Today or t0
Interest Rate = r
PV (price)
Price =
FV
or FV(1 - rt) depending on rate type
or
1+rt
(1+r)t
FV
Forward Deposit
A client wants to deposit 10,000,000 for 3 months
But not starting today
Instead wants to do it in two months time
A bank agrees today to take the deposit at an agreed rate of 5.25%
Cash flows on the forward deposit:
10,131,250
Today plus 2 months

Today or t0
Today plus 5 months
10,000,000
7
Alternatives to Forward Deposit

Forward Deposits or loans are risk positions for the bank and the client
If the client does not actually deposit the cash, the bank might have to pay a
higher rate to fund itself
If the bank defaults on the agreement, the customer might have to deposit
elsewhere at a lower rate
Usually institutional or corporate clients will lock-in rates by using Forward
Rate Agreements (FRAs) or Futures
Forward Rate
Bank agrees to fix a rate for a client on a 10,000,000 deposit
Deposit will take place in 2 months
Deposit will mature 3 months later
Bank and the client agree to a rate of 5.25%
5.25% is the 2 x 5 forward rate
Rate agreed today
For a deposit or loan that begins in 2 months
And terminates or matures in 5 months
Bank has NOT agreed to take a deposit or make a loan

Bank and the client have agreed if the deposit rate in 2 months is
Less than 5.25%, the bank will pay the interest shortfall to the client
More than 5.25%, the client will pay the excess interest to the bank
Example
FRA (Forward Rate agreement)
FRA settlement is
If the 3 month rate in 2 months is

5.00%
Up-front:
10,000,0000.0025
1
1+ 0.0500
4
1
4
= 6172.84
If the 3 month rate in 2 months is

5.50%
10,000,0000.0025
1
1+ 0.0550
4
1
4
= 6165.23
When the start date of the

deposit/loan occurs
Discounted
The interest variation from the agreed
rate on the notional amount is
calculated
Then it is discounted by the observed
rate for the period of the deposit or
loan
Instead of paying it out at the end of
the period
In reality daycount is not exactly
Contract can be tailored
10
Exchange Traded Version of the FRA

Short Term (3 month) Interest Rate Future
All terms standardised
Future = 94.75 corresponds to a rate of 100 94.75 = 5.25%
One basis point (0.01%) is worth
1,000,000 x 0.0001 x = 25 for EUR, USD
500,000 x 0.0001 x = 12.50 for GBP
Futures are marked to market every day

Buy 10 futures on EUR rate for 94.75 today
Future closes at 95.00
Future closes at 94.50
Receive EUR6250 tomorrow
Pay EUR6250 tomorrow
10 Futures x 25 Basis Points x EUR25 per Basis Point
11
Par Yield / Par Coupon / Par Swap Rates

Usually represented by bonds or by interest rate swaps
Pay 100 today
5-year annual Par rate of 6.00%
Receive fixed coupon of 6 each year for 5 years
In 5 years receive 100
100 is the principal amount
6.00% is the par coupon rate or par yield rate or par swap rate
Its the fair or current rate
12
Cash Flows on a Par Bond
100
6
6
4
6
5
100
What happens when 6% becomes unfair?
13
Floating Rate Note (its always fair)
100
?
100
Rate is unknown but resets to what is fair/current
We say that the rate is floating
Is always worth 100
14
A Fair Exchange
These two are both worth 100 today
100
?
Floating Rate Note
100
6
6
4
Fixed Rate Bond
The payments of 100 in year 5 are worth the same today so . . .

15
These are worth the same
6
4
6
5
16
So this is worth 0 (Par)

?
If you agree to pay 6 every year for 5 years and are paid the 1 year rate that is
fair/current at each payment date
This exchange has a present value of 0
It is a fair trade
Its called an interest rate swap
17
Interest Rate Swap

An interest rate swap is a tailored agreement between two counterparties:
In this case, for five years
One party agrees to pay a floating rate
One party agrees to pay a rate fixed at the start
Payments are netted
The fixed rate on a swap worth 0 is called the par swap rate
18
Interest Rate Swaps

Interest Rate Swaps are fair value agreements so long as the fixed rate is the
current rate for its maturity
In 1979 the World Bank and IBM did a landmark swap transaction
Since that time interest rate swaps have become a commodity
In a single currency interest rate swap there is no exchange of the principal
amount
So the notional size needs to be agreed as well
Interest Rate Swaps are among the most frequently used derivatives in the
financial world
You can learn about their uses in the Interest Rate Swaps course
19
The Yield Curve

The graph of the rate (y axis) for each point in time (x axis) is called the yield
curve
There are different yield curves for
Spot rates
Forward/futures rates
Par rates
There are different yield curves for different

Currencies
Credit qualities
Quote conventions e.g. add-on, discount, compounded
The yield curve is also called the term structure of interest rates
20
Curve Building
SECTION 1
Rate Arbitrage
Market Rates
Yield Curves = Term (time) Structure Of Rates
Consider other currencies and different qualities

3
Types of interest rate

Spot/zero rate
Forward rate
Par yield/coupon/swap rate

Spot rates
0
t1
0
t2
0
t3

Forward rates
0
t1
t1
t2
t2
t3

Par bond yields
0
t1
0
t2
0
t3
Where do we see these trading?

Spot rate
deposits
t-bills
CP
Forward rate
FRAs
Eurodollar futures, Short sterling futures etc
Par bond yield

bonds
swaps
Interest Rate relationships

Spots, forwards and pars seem to be related - consider these cashflows...
105
0
t1
100
t1
106
t2
99
=
0
6
t1
100
6
t2
100
9
Is there an opportunity?
3 mo rate = 5% p.a.
6 mo rate = 6.00% p.a.
3 x 6 forward = 6.00% p.a.
10
Spot and Forward

1
3M
0
1.0125
6M
0
3M
1
1.0125
3M
1.0125 x 1.015=1.0276875
6M
0
1.0125
1.0276875
11
Spot Only
1
6M
0
1.03
12
No Arbitrage
Arbitrage-free relationship means
no profit at expiry
Cashflows are the same at expiry
What is the arbitrage-free 3x6 forward rate?

Arbitrage-free rates are
Fair?
Correct?
An academic idea?
13
No Arbitrage
Spot and Forward trade: 1
3M
0
1.0125
6M
0
3M
1.0125 x ????=1.03
Spot only trade:
1
6M
0
1.03
14
To be arbitrage-free what is the forward?

For there to be no arbitrage, should be around 7%
More precisely
1.01125 x ( 1 + r3x6 t) = 1.03
which means that

1 + r3x6t = 1.03 / 1.0125
1 + r3x6t = 1.017284
r3x6t = 0.017284
As t= , r3x6 = 0.017284 x 4 = 0.0691358
or 6.91358% p.a.
Note that 6M spot rate is almost the average of the forward rates covering the
same time period
15
SECTION 2
Yield Curve Building
Forwards to spots
Using this arbitrage relationship, we can relate spot and forward rates
together
Imagine we knew a series of forward rates and wanted to find the spot rates:
Why would we want to do this?
17
Start with the forwards

Year:
Forward
0.0500
0.0625
0.0725
0.0800
0.0825
Spot
NB The forward rate given is for a 1 year investment ending at the given year
18
1 year forward vs 1 year spot

Remember that our first forward starts at time 0, and so is the same as a spot
rate
1 year spot:
0
t1
0 x 1 forward:
0
t1
1 year spot must also be 5%
19
Find the 2 year spot rate

If we invest 1 for 1 year at the 1 year spot rate, we get
1.0500
If we agree today to reinvest this at the 1 year forward 1 year rate, we get
1.05 x 1.0625 = 1.115625
The arbitrage argument says that we must get the same FV if we invest for 2
years at the 2 year spot rate
So, using the bond calculator
PV = -1, FV = 1.115625, n = 2, PMT = 0
Press the i button
i =5.623%
Repeat for the remaining spot rates
20
Forwards to spots
0
Zero rate
Forward rate
1
2
3
4
5
5.0000%5.6232%6.1627%6.6191%6.9433%
5.0000%6.2500%7.2500%8.0000%8.2500%
21
Discount factors
Used to present value cashflows
One year discount factor:
Two year discount factor:
1
1
(1+r)
1
(1+r)
1
(1+0.05)1
= 0.9524
1
(1+0.0562)2
= 0.8964
22
Discount factors
0
Zero rate
Forward rate
Discount Factor (df)
1
2
3
4
5
5.0000%5.6232%6.1627%6.6191%6.9433%
5.0000%6.2500%7.2500%8.0000%8.2500%
0.9524 0.8964 0.8358 0.7739 0.7149
Note:
df1 = 1/ ( 1+ r0x1)
df1 = 1/ ( 1+ r1)
df2 = df1 / (1 + r1x2)
df2 = 1 / (1 + r2)2
df3 = df2 / (1 + r2x3)
df3 = 1 / (1 + r3)3
etc.
23
Cumulative discount factors

What is the value of 1 currency unit to be paid every year for 4 years?
0.9524+0.8964+0.8358+0.7739 = 3.4585
we call this the 4-year cumulative discount factor (CDF4)
this is useful for pricing annuities
e.g. 800 every year for 4 years is worth 2,766.8 today
24
Cumulative discount factors

0
Zero rate
Forward rate
Cumulative DF (cdf)
1
2
3
4
5
5.0000%5.6232%6.1627%6.6191%6.9433%
5.0000%6.2500%7.2500%8.0000%8.2500%
0.9524 0.8964 0.8358 0.7739 0.7149
0.9524 1.8487 2.6845 3.4584 4.1732
25
Par yield/coupon/swap Rate

We would like to find a bond coupon curve which is consistent with our spot
and forward curves
Consistent means arbitrage-free or same cashflows at expiry
We will find the par yield /coupon/ swap rate curve
We want to find the yields on the 1 through 5 year maturity bonds which will
price at par in this environment
Consider the 1-year annual par bond:
0
100
c1
1
100
What is the consistent or fair rate for c1?

26
3-year par bond

100
0
c3
c3
c3
3
100
100 = c3 x 3-year cumulative discount factor + 100 x df3

100 = c3 x 2.6845 + 83.58
c3 = (100 - 83.58 ) / 2.6845 = 6.1166 %
In general:
couponn =
1dfn
cdfn
27
Par yields
0
Zero rate
Forward rate
Cumulative DF (cdf)
Swap / Coupon rate ( c)
1
2
3
4
5
5.0000%5.6232%6.1627%6.6191%6.9433%
5.0000%6.2500%7.2500%8.0000%8.2500%
0.9524 0.8964 0.8358 0.7739 0.7149
0.9524 1.8487 2.6845 3.4584 4.1732
5.0000%5.6061%6.1179%6.5390%6.8321%
28
Spot, Forward and Par Yield Curves

5-Year Yield Curve
8.50%
8.00%
7.50%
7.00%
Zero rate
Forward rate
6.50%
6.00%
Swap / Coupon rate
5.50%
5.00%
4.50%
0
Year
Spot rates are like averages of forward rates

spots are lower (in an upward-sloping environment)
spots are higher (in an downward environment)
Par rates give opportunity/cost for reinvestment

higher forwards give a lower par yield than the spot rate
lower forwards give a higher par yield than the spot rate
29
Building Yield Curves

We know that
Zero rates
Forward rates
Par rates
Are all related

If we have a complete set of rates of one type i.e. for each point in time
Then we can use that curve to build the others
30
US Treasury Strips
A strip is the coupon from a US
Treasury bond or note
It looks exactly like a zero coupon
bond
You pay the price today
No cash flow occurs until maturity
Redeems at its face value
22-Dec-04
22-Dec-05
22-Dec-06
22-Dec-07
22-Dec-08
22-Dec-09
22-Dec-10
22-Dec-11
22-Dec-12
22-Dec-13
22-Dec-14
Price
97.6439
94.6466
91.2007
88.0232
84.1442
80.1777
76.1562
72.3795
68.6497
65.0534
31
Zero Coupon Rates on 22/12/2004

We can calculate the annual
compounded zero coupon rate for
each year for which we have the
Price of a Treasury Strip
The formula is
1
price
Alternatively use a bond calculator

n
i
PV
PMT
FV
22-Dec-04
22-Dec-05
22-Dec-06
22-Dec-07
22-Dec-08
22-Dec-09
22-Dec-10
22-Dec-11
22-Dec-12
22-Dec-13
22-Dec-14
Price
97.6439
94.6466
91.2007
88.0232
84.1442
80.1777
76.1562
72.3795
68.6497
65.0534
Zero rate
2.4129%
2.7892%
3.1179%
3.2406%
3.5131%
3.7507%
3.9679%
4.1233%
4.2681%
4.3934%
32
Zero Coupon Curve
Zero Coupon Rates

5.0000%
Rate
4.0000%
3.0000%
2.0000%
1.0000%
0.0000%
28-May- 10-Oct- 22-Feb- 06-Jul- 18-Nov- 01-Apr- 14-Aug- 27-Dec- 10-May05
06
08
09
10
12
13
14
16
time
33
Par Yields
We can use this method to determine all
the par yields for the same time periods
as the zero coupon rates.
1 dfn
The formula is: couponn =
cdfn
df
cdf
par
0.97644
0.94647
0.91201
0.88023
0.84144
0.80178
0.76156
0.72380
0.68650
0.65053
0.97644
1.92291
2.83491
3.71514
4.55659
5.35836
6.11993
6.84372
7.53022
8.18075
2.4129%
2.7840%
3.1039%
3.2238%
3.4798%
3.6993%
3.8961%
4.0359%
4.1633%
4.2718%
34
Zero Yields and Par Yields
5.00%
zero and par yields
4.50%
yield
4.00%
3.50%
3.00%
2.50%
2.00%
14-Jan-04 10-Oct-06 06-Jul-09 01-Apr-12 27-Dec-14 22-Sep-17

time
35
Forward Rates
From year 4 to 5:
1
df5 = df4
1+r
4x5
1-year FVF for year 4 to 5:

df
(1 + r4x5 ) = df4
5
Forward rate from years 4 to 5:

df4
r4x5 = df 1
5
In general rate from year n to year m:

df
rnxm = dfn 1
m
df
0.976439
0.946466
0.912007
0.880232
0.841442
0.801777
0.761562
0.723795
0.686497
0.650534
Forward
2.4129%
3.1669%
3.7784%
3.6098%
4.6100%
4.9472%
5.2806%
5.2178%
5.4331%
5.5282%
36
Zero Yields, Par Yields and Forward Yields
Zero, Par and Forward Curves

6.00%
5.50%
Yield
5.00%
4.50%
Zero rate
4.00%
par
3.50%
Forward
3.00%
2.50%
2.00%
14-Jan- 10-Oct- 06-Jul- 01-Apr- 27-Dec- 22-Sep04
06
09
12
14
17
Time
37
Bootstrapping
We built the yield and forward curves using zero coupon bonds
In markets other than the US Treasury it is not possible to do this
The Strip market does not exist or
The strips are not liquid enough to give a stable curve
In that case we might want to simply start with the par curve and back out
the discount factors i.e. the zero coupon rates
This process is called bootstrapping.
38
Bootstrapping
The yields on German Government
Bonds on 22/12/2004 are shown here.
Since the one year yield is 2.30405
The one year zero rate is 2.30405
The one year discount factor is
1/(1.0230405) = 0.977479
That was easy

What about the two year zero and
the two year discount factor?
Date
22-Dec-05
22-Dec-06
22-Dec-07
22-Dec-08
22-Dec-09
22-Dec-10
22-Dec-11
22-Dec-12
22-Dec-13
22-Dec-14
Yield
2.3040%
2.4708%
2.6026%
2.8200%
2.9996%
3.1761%
3.3147%
3.4398%
3.5399%
3.6336%
39
Two Year Rate

The two year par yield is 2.4708
2.4708
So a 2 year bond with a coupon of

2.4708 is worth 100
102.4708
We could calculate the value by

discounting the cash flows:
100
100 = 2.4708 0.97748 + 102.4708 df2
We can use this to solve for the

second discount factor:
0.97748
df2 = 100 2.4708
102.4708
df2 = 0.952319
40
Continuing the Process

Every time we calculate a
discount factor we can use
it together with the next
yield to calculate the next
discount factor:
This process is called
Bootstrapping the curve
General formula:
n1 )
dfn = (1cn1+CDF
c
n
Date
22-Dec-05
22-Dec-06
22-Dec-07
22-Dec-08
22-Dec-09
22-Dec-10
22-Dec-11
22-Dec-12
22-Dec-13
22-Dec-14
Yield
2.3040%
2.4708%
2.6026%
2.8200%
2.9996%
3.1761%
3.3147%
3.4398%
3.5399%
3.6336%
df
cdf
0.977479
0.952319
0.925683
0.894257
0.861676
0.827262
0.793425
0.759503
0.726777
0.694316
0.977479
1.929797
2.855481
3.749738
4.611414
5.438676
6.232101
6.991604
7.718381
8.412697
Zero
2.3040%
2.4729%
2.6075%
2.8334%
3.0223%
3.2110%
3.3609%
3.4984%
3.6096%
3.7156%
41
Homework Exercises
UBS sells an FRA on GBP50 million to Given these 1 year rates:
a client
0 x1
1x2 2x3 3x4 4x5
Rate = 6.50%
Period is 6 months x 12 months
8.00
7.50 7.25 7.10 6.90
When the FRA expires the 6 month

rate turns out to be 6.10%
Find the discount factors for 1, 2, 3, 4

and 5 years
Who pays on the FRA?
Use these to find the 1, 2, 3, 4 and 5

year zero coupon rates
How much is the settlement

amount?
Calculate the CDFs for 1, 2, 3, 4 and 5

years
Use these and the DFs to find the 1,
2, 3, 4 and 5 year par yields
42
Fixed Income Fundamentals

1. Interest Rate & Bond Calculations Day 2
Bond Valuations and Yields

Bond Valuation Using a Yield Curve

Year
Spot
4%
5%
6%
7%
DF
CDF
Value the 4-year annual 5% bond
Guess the single rate to PV all cashflows at to get to the same value?
5
Or would you rather solve quadratic polynomial, PV = 1+ y +
5
105
+
+
?
(1+ y )2 (1+ y )3 (1+ y )4
Bond Valuation Using a Yield to Maturity

Year
Ytm
y%
y%
y%
y%
DF
CDF
Yield to Maturity
YTM is the one rate to discount all of the bonds future cash flows to its price
Its like a weighted average of spot rates
YTM depends on rates and cashflows on the bond
People sometimes say:
YTM is the expected return to the bond investor
YTM is the assumed reinvestment rate of the bonds coupons
YTM is the equivalent rate on a deposit of the bonds price for the time to maturity
of the bond
Yield to Maturity - Example I

4 year 5% bond yielding 5%
Year
Cashflow
1
2
3
4
DF
5
5
5
105
Present value
1/1.05 = 0.9524
1/1.052 = 0.9070
1/1.053 = 0.8638
1/1.054 = 0.8227
4.7619
4.5351
4.3192
86.3838
Total
100.0000 (par)
105
5
4.7619 4.5351 4.3191 86.3838

100
Future
values
Present
values
Yield to Maturity - Example II

Year
Cashflow
1
2
3
4
DF
5
5
5
105
Present value
1/1.06 = 0.9434
1/1.062 = 0.8900
1/1.063 = 0.8396
1/1.064 = 0.7921
4.7170
4.4500
4.1981
83.1698
Total
96.5349 (discount)
105
5
4.7170 4.4500 4.1981 83.1698
Future
values
Present
values
96.5349
5
Yield to Maturity - Example III

Year
1
2
3
4
Cashflow
DF
5
5
5
105
Present value
1/1.04 = 0.9615
1/1.042 = 0.9246
1/1.043 = 0.8890
1/1.044 = 0.8548
4.8077
4.6228
4.4450
89.7544
Total
103.6299 (premium)
105
5
4.8077 4.6228 4.4500 89.7544
Future
values
Present
values
103.6299
6
Price and Yield
Homework Exercises
Annual Coupon = 7.00%
Annual Coupon = 10%
Time to Maturity = 6 years
Time to maturity = 5 years
YTM = 6.20%
Price = 110
Price =
YTM =
Semi-annual Coupon = 6.00%
Semi-annual coupon = 5.50%
Time to maturity = 5.50 years
YTM = 7.25%
Price = 97.55
Price =
YTM =
Exercises
Annual coupon = 9.00%
Semi-annual coupon = 12%
YTM = 8.00%
YTM = 10%
Price =
Price =
Assuming all coupons can be

reinvested at 8.00%, calculate the
total cash amount at maturity of the
bond
bond
Calculate the return
Bond Valuations and Yields

Bond Valuation Using a Yield Curve

Year
Spot
4%
5%
6%
7%
DF
CDF
Guess the single rate to PV all cashflows at to get to the same value?
5
Or would you rather solve quadratic polynomial, PV = 1+ y +
5
105
+
+
?
(1+ y )2 (1+ y )3 (1+ y )4
Bond Valuation Using a Yield to Maturity

Year
Ytm
y%
y%
y%
y%
DF
CDF
Yield to Maturity
YTM is the one rate to discount all of the bonds future cash flows to its price
Its like a weighted average of spot rates
YTM depends on rates and cashflows on the bond
People sometimes say:
YTM is the expected return to the bond investor
YTM is the assumed reinvestment rate of the bonds coupons
YTM is the equivalent rate on a deposit of the bonds price for the time to maturity
of the bond
Yield to Maturity - Example I

Year
Cashflow
1
2
3
4
DF
5
5
5
105
Present value
1/1.05 = 0.9524
1/1.052 = 0.9070
1/1.053 = 0.8638
1/1.054 = 0.8227
4.7619
4.5351
4.3192
86.3838
Total
100.0000 (par)
105
5
4.7619 4.5351 4.3191 86.3838

100
Future
values
Present
values
Yield to Maturity - Example II

Year
Cashflow
1
2
3
4
DF
5
5
5
105
Present value
1/1.06 = 0.9434
1/1.062 = 0.8900
1/1.063 = 0.8396
1/1.064 = 0.7921
4.7170
4.4500
4.1981
83.1698
Total
96.5349 (discount)
105
5
4.7170 4.4500 4.1981 83.1698
Future
values
Present
values
96.5349
5
Yield to Maturity - Example III

Year
1
2
3
4
Cashflow
DF
5
5
5
105
Present value
1/1.04 = 0.9615
1/1.042 = 0.9246
1/1.043 = 0.8890
1/1.044 = 0.8548
4.8077
4.6228
4.4450
89.7544
Total
103.6299 (premium)
105
5
4.8077 4.6228 4.4500 89.7544
Future
values
Present
values
103.6299
6
Price and Yield
Homework Exercises
Annual Coupon = 7.00%
Annual Coupon = 10%
YTM = 6.20%
Price = 110
Price =
YTM =
Semi-annual Coupon = 6.00%
Semi-annual coupon = 5.50%
Time to maturity = 5.50 years
YTM = 7.25%
Price = 97.55
Price =
YTM =
Exercises
Annual coupon = 9.00%
Semi-annual coupon = 12%
YTM = 8.00%
YTM = 10%
Price =
Price =

bond
bond
Bond Futures
SECTION 1
Futures Contracts
Bond Futures
Are an exchange traded contract
Allow investors to gain exposure to bond yields
Allow hedgers to reduce their exposure to bond yields
Like all futures contracts they are marked to market and can be offset before
expiry
The futures months are March, June, September and December (H, M, U, Z are
the symbols) with a separate contract for each expiry
Example
The September 2005 Treasury Note Futures contract was priced at 108 20 on
30 March 2005
Quotation is in 32nds so this means a decimal price of 108.625
The underlying to the contract is a
US Treasury Note
10 years to maturity on the first day of the futures month
Semi-annual coupon of 6%
Face amount of USD100,000
Buying the future is like agreeing today to buy this note in September
(So the price of the future is not the cash price of the note)
Deliverable Bonds
The nominal underlying (6% coupon, 10 years to maturity) is an ideal
In reality the person who is short the future chooses which of a list of
deliverable bonds to deliver
Criteria:
Must be US Treasury Note
At least 6 years but not more than 10 years remaining to maturity at the first
date of the futures month
Payment to the short is:

Futures Price x Conversion Factor for Delivered Bond
Conversion Factor = price of the bond at 6% ytm on the first date of the futures
month
Example
A Bond Fund manager buys the September 10 year future at a price of
108-20
In September the manager is still long the contract
On 7 September a person who is short decides to deliver the 4% US
Treasury note maturing on 17 February 2014
The manager is selected to take delivery
CBOT notifies the manager that delivery will occur on the next business
day (8 September)
The conversion factor for the note is 0.8713 (see Appendix or CBOT web
site)
Payment to the short is: 0.8713 x 108.625 = 94.64 (plus accrued interest)
Futures Contracts
Bond Futures are among the most successful of all futures contracts
There are futures on 5 year and 10 year notes in many markets:
Germany
UK
US
Japan
In the US market there are also futures on 2 year and 30 year bonds but the
most popular and liquid contracts are the 10 year futures
SECTION 2
Appendix: Conversion Factors
Calculation of the Conversion Factor

For US Bond and Note futures the CBOT uses this method for calculating the
conversion factor:
Determine the amount of time left to maturity of the bond or note from the
first day of the futures month
Round this number DOWN to the nearest 3 months
Calculate what the price of the bond or note would be if it had this amount of
time left to maturity and was priced to yield 6%
Example
4% Treasury Note maturing on 17/02/2014
Conversion factor relative to the September 2005 Future
Time to maturity from 1/09/2005 to 17/02/2014 is 8.25 years rounded
down to the nearest quarter year (actual time is 8 years 5 months and 17
days)
We used excel as shown below (note that 8.25 years from 1/09/05 is
1/12/13)
settle
maturity
coupon
ytm
freq
face
price
01-Sep-05
01-Dec-13
0.04
0.06
2
100
87.12676
9
Bond Repo and Carry Costs

SECTION 1
Repo
The Repo Market

Bond Traders / Market-Makers /
Dealers
Investors / Government Agencies /

Pension Funds / Insurance Companies
Have a need to finance bonds they

own borrow cash
Want to earn interest on unneeded

cash lend cash
Need to access bonds they have sold Sometimes want to raise cash for
investment purposes lend bonds
short borrow bonds
They do both of these in the Repo
Market
They do both of these in the Repo

market
Repo market
Money market: Short term loans
Collateral
US Treasury bonds
Sovereigns
Highly rated corporates
Examples
UBS buys 10 million of a UKT from a A hedge fund wants to sell $50
client
million of UST bond
Still has the position at the end of
the day
Needs to be funded
Sells the bond in the market

Borrows the bond in the repo market
Lend the bond in the repo market
Gives up the cash received for the

bond
Take in the cash price
Delivers the bond to the buyer
Tomorrow if we sell the bond
When it wants to close the trade:
Repay the loan

Get the bond back
Buys the bond in the market

Returns it in the repo market
Is paid cash plus interest
Pays the seller of the bond
Repo transaction
Repo: Repurchase agreement
Today: UBS buys a UK Treasury bond from a customer
UBS borrows purchase price from Salomon Brothers
giving the bond as collateral
In a few days, UBS sells the bond to another customer

UBS pays the original purchase price plus interest
to Salomon
UBS receives the bond back from Salomon and delivers
it to the customer, receiving new full price
Repo
UBS has done a repo transaction
Repo borrow money giving a bond as collateral
Salomon Brothers has done a reverse-repo transaction
Reverse-repo lend money, taking a bond as collateral
Repo Rates
General Collateral
general level of repo rates for all bonds of a given issuer
e.g. all Gilts
Special
different repo rate for a particular issue
Example expanded
UK Treasury 5s 7th Dec 09
Settlement date :
1 Mar 2004
Cash Price:
102.70
Accrued Interest:
1.335
Invoice Price:
104.035
UBS
buys 10,000,000 face value
borrows 10,403,538 from Salomon at 5.6%, depositing bond as collateral
(Repo rate in the UK is actual/365)
Repo Transaction
Start:
Bond
Salomon
Bond
UBS
Invoice
price
Repo transaction
Customer1
Invoice
price
Outright purchase
Repo Example
Suppose UBS sells the bond a few days later:
New invoice
price
Repay loan
Salomon
UBS
Bond
Customer2
Bond
Settlement date:
8 March 2004
New cash price:
102.00
New accrued interest:
1.445
Invoice price:
103.445
UBS sells 10,000,000 face value,

Receives (on sale)
10,344,535
Pays (on repo close out)
10,403,538 x ( 1 + 5.6% x 7/365)

= 10,414,711
10
Analysis of Transaction
Total P/L
Receives 10,344,535
Repays 10,414,711
Net
(70,176)
This can be decomposed into:

Price change:
( 102.00 102.70 ) x 100,000 = (70,000)
Coupon earned:
5.75/2 x 7/183 x 100,000
Interest paid:
10,403,538 x 0.056 x 7/365 = (11,173)

Total
= 10,997
(70,176)
11
SECTION 2
Carry Cost
Financing positions
When we put on bond positions we care about carry cost:
How much is paid / earned to be long a bond?
In this case
Earn coupon:
10,997 per 10m face for 7 days
0.01571 per 100 face per day
Pay repo:
11,173 per 10m face for 7 days
0.01596 per 100 face per day
In this case Net Carry = - 0.00025 per 100 face per day
Negative carry means there is a net cost to hold the bond
13
The Punchline
A bond forward is just like a bond future
Forwards are priced using a cost of carry principle
In the bond example before, what is the fair 7-day forward price?
14
Bond Risk
Bond Price and Yield Curve

Bond prices are determined by the yield curve
Bond price risk stems from yield curve changes
In this section, we seek to quantify this risk
Risk measures are used to
hedge
implement views
When the yield or interest rates go up, the price of a bond drops
When the yield or interest rates drop, the price of a bond increases
What is Risk?
Risk is exposure to change
Which is riskier, a USD bond issued by
US Treasury?
UBS?
Which is riskier?
2 year US Treasury note
30 year US Treasury bond
We will focus on market/price risk

how does the value (price) of a bond change as interest rates change?
Bond Risk
Single Cash flow - Zero Coupon Bonds

We first consider zero-coupon bonds
How does the value of a single cashflow change?
Interest rates = 10%
Zero coupon bond values:
Maturity
1
2
5
10
30
Value today
90.909
82.645
62.092
38.554
5.731
What if rates go to 10.1%?
Single Cashflow
If rates go up to 10.1%, the values go down
Values before and after, and changes:
Maturity
1
2
5
10
30
10%
10.1%
Value today New value
90.909
90.827
82.645
82.495
62.092
61.811
38.554
38.206
5.731
5.577
Change % Change
-0.083
-0.09%
-0.150
-0.18%
-0.281
-0.45%
-0.349
-0.90%
-0.154
-2.69%
% change seems to be proportional to the time to maturity
Single Cashflow
% price change is proportional to maturity
In the example, % price change = 0.0009 x maturity
Where does the number 0.0009 come from? It turns out that
0.0009
% price change =
Price change =
yield change
1 + yield
yield change
1 + yield
0.10 0.1010
1+ 0.10
yield change
1 + yield
] maturity
] maturity
price
Weighted Average Maturity - continued

You have this portfolio:
$500 of a 1-year zero coupon bond
$500 of a 5-year zero coupon bond
The price risk is the same as $xxxx of a x-year zero coupon bond
Weighted Average Maturity - Example

What if you have:
$500 of 1 year
$200 of 3 year
$300 of 5 year
In this case
500
1000
) (
1 +
200
1000
) (
3 +
300
1000
5 = 2.6
The price risk is the same as:

$1000 of 2.6 year ZCB
Instead of thinking of the portfolio as 3 bonds of different maturities, we

think of it as $1000 invested in 2.6 year zero coupon bonds
Risk on a Bond
A bond is like a portfolio of cashflows
We know how to measure the risk on a single cashflow - it is proportional to
the maturity of the cashflow
We can take a portfolio of cashflows and find a single cashflow that is
equivalent to the portfolio in terms of price risk
Bond Price
4 year bond with 8% coupon
Yield = 7%
What is the price?
4 n
100 FV
8 PMT
7 i
PV = 103.39
But how is the price made up?
10
Bond as a Portfolio
Bond value broken down:
Year
1
2
3
4
Cashflow Value
8
7.48
8
6.99
8
6.53
108
82.39
103.39
The bond is like

7.48 of the 1 year cashflow
So what is the maturity of the single cashflow that is equivalent?
11
Bond Duration
Bond is like a portfolio where
7.48 / 103.39 = 7.2% is invested in the 1 year ZCB
This is equivalent to 103.39 invested in the 3.58 year zero-coupon bond:
Year
1
2
3
4
Cashflow Value
Proportion Proportion x maturity
8
7.48
7.2%
0.072
8
6.99
6.8%
0.135
8
6.53
6.3%
0.189
108
82.39
79.7%
3.188
103.39
1.00
3.58
12
Macauley Duration
3.58 years is the maturity of the zero-coupon bond that has the same
sensitivity to interest rate changes as this coupon bond
It is called the bonds Macauley Duration
A 3.58-year zero coupon bond has risk defined by:
Price change = [ yield change / ( 1 + yield) ] x 3.58 x price
Our coupon bond has the same sensitivity, so:

Price change = [ yield change / ( 1 + yield) ] x 3.58 x price
So, for a coupon bond:

Price change = [ yield change / ( 1 + yield) ] x Duration x price
= [ Duration / ( 1 + yield) ] x price x yield change
13
Price Value of a Basis Point (PVBP)

Price change =
duration
1 + yield
] price yield change
modified duration
For our bond, modified duration = 3.58 / 1.07 = 3.35

For a 1 b.p. change in yield, the change in price is
( 3.35 x 103.39 x 0.01%) = -0.0346
This is called the Price Value of a Basis Point (PVBP)
If the yield goes from 7% to 7.01%, we expect the price to go down by 3.46
cents on a $100 face. Lets check
14
Testing PVBP
Using PVBP, we can predict changes in price from changes in yield:
down 100 down 1
current
up 1
up 100
106.85
103.42
103.39
103.35 99.92353
How do these compare with actual bond prices (using bond calculator)
PVBP only seems to work for small changes
Predicted
Actual
down 100 down 1

current
up 1
up 100
106.85
103.42
103.39
103.35
99.92
106.93
103.42
103.39
103.35
100
15
Gamma
115.00
110.00
Price
105.00
100.00
95.00
90.00
4
10
Yield
Predicted
Actual
4
113.78
114.52
4.5
112.05
112.56
5
110.31
110.64
5.5
108.58
108.76
6
106.85
106.93
6.5
105.12
105.14
6.99
103.42
103.42
7
103.39
103.39
7.01
103.35
103.35
7.5
101.66
101.67
8
99.92
100
8.5
98.19
98.36
9
96.46
96.76
9.5
94.73
95.19
10
93.00
93.66
16
Gamma
PVBP (or bond delta) depends on the yield too
As yields increase, the PVBP decreases because the price of the bond and its
duration decrease
Gamma is the measure of how the PVBP changes when yields change
17
Another View of Duration

A bond has two risks
Price risk
change in price due to change in yield
Reinvestment risk
change in coupon reinvestment income due

to change in yield
These risks move inversely

The point in time where they cancel each other out is
called the Duration
What does this mean?
18
Example
4 year, 5% coupon bond yielding 7%
Year
1
2
3
4
Cashflow
5
5
5
105
Total
Present value
% of price
4.6729
4.3672
4.0815
80.1040
0.0501
0.0468
0.0438
0.8592
93.2256
1.0000
The Macauley duration

D = 1 0.0501 + 2 0.0468 + 3 0.0438 + 4 0.8592 = 3.712156
19
Example - continued
Suppose immediately after we purchase the bond, the yield either rises to
8% or falls to 6%
New price at 8% = 90.06 - Did we lose money?
New price at 6% = 96.53 - Did we make money?
What if we hold the bond for several years?

Holding
Period
Return
(YTM=6%)
Return
(YTM=7%)
Return
(YTM=8%)
1 year
9.76%
7%
4.34%
2 years
7.87%
7%
6.15%
3 years
7.24%
7%
6.76%
4 years
6.93%
7%
7.07%
If we hold the bond for 3.71 years, the bond will return 7%
20
Macauleys Duration
Also can be understood as the point in time where the
past and future cashflows are balanced (as in a see-saw)
10% coupon, 4-year bond
8% yield to maturity
74
9.3
8.6
7.9
7.4
4
Macauley Duration is 3.504 years
21
Factors affecting Duration

Duration is impacted by all things that determine the
price of a bond
coupon
yield
time to maturity
frequency of
coupon payments
22
Zero Coupon Bond
23
Increasing coupon
24
Increasing yield
25
Increasing time
26
Increasing coupon frequency
27
Exercise: Risk Measures of German Bond
28
Exercise: Risk Measures of German Bond
29

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What are money market rates?

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What is the difference between future value and present value?

Fixed Income Fundamentals

1. Interest Rate & Bond Calculations Day 1

Financial Markets Education

Financial Markets Education

Money Market Rates

Money Centre Banks

Banks, Thrifts, Building Societies

Brokerage sweep accounts

Money Market Funds

All either have excess funds or need

All of these take in cash deposits

Money Market rates are usually addon

Interest Rate Terminology

Real Cash Flows:

Future Value / Present Value

How much needs to be deposited at 5% for 1

Future Value Factor / Discount Factor

More Examples: Your turn

Nominal and Effective Rates

A Rate, Time Period and a Compounding Frequency determine a FVF and a DF

The Dreaded Formulae!

Suppose you have the FVF?

Most Common Problem

Review: Discount Rates

Treasury Bill Discount Rate

Price = 10,000 - 116.28 = 9883.72

Discount Rate = 4.60%

What are the DF and FVF for these

What is the effective rate if

Rate = 12% p.a. quarterly

Rate = 4% p.a. monthly

What is the DF and FVF for these

2 months ______ ______

6 months ______ ______

What simple rate would have the

What semi-annual compounded

A 26-week T Bill is trading at a 5%

What quarterly compounded rate

What is its BEY?

Continuously Compounded Interest

The limit is called continuous interest

Conversions Using Day Counts

And the other way

The Yield Curves

But how do we build the curves?

USD LIBOR 1998

Government Yield Curves

Types of Interest Rates

We want to arrange today to invest at some time in the future, we want a

We want to receive a fixed (constant) interest payment periodically, we want

Spot Rate Example

Deposit money at a bank for 9

A 3-year zero coupon bond is trading

Bank quotes a rate of 6.00%

Pay 81.63 today

2 months

6 months