ACTL2111 : Financial Mathematics S1 2017

Module 4 - Interest Rate Risk

Tharitha Murage

1 Term Structure of Interest Rates

We know interest rates depend on the maturity of the investment. In general longer term invest-
ments have higher interest rates.

1.1 Shapes of the Yield Curve

There can be three types,

Normal

Inverse

Humped They are illustrated by the image below

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1.2 Definitions

1.2.1 Forward Rates & Spot Rates

Defn : Forward Rates : Forward rate is the effective annual rate of interest set today for an
investment of $1 in the period (t1 , t2 ), where t2 t1 0
Notation : Forward Rates
Forward Rate : ft1 ,t2
Defn : Spot Rate : Spot rate is the effective annual rate of interest for an investment of $1 today
for t years. i.e a forward rate where t1 = 0 Notation : Spot Rate

Spot Rate : st = f0,t

Thinking in Terms of Accumulation Functions

  1
a(t2 ) t2 t1
Forward Rate : 1 + ft1 ,t2 =
a(t1 )
1
Spot Rate : 1 + st = a(t) t
How are Spot Rates determined in real life?

Observing the market - speculation by the market participants

Looking at the prices of the Zero Coupon Bonds (ZCB)

Note : The forward rates often follow the spot rates.

1.3 Calculating Spot Rates from Price of ZCB

If given the price (P) of a ZCB with t years to maturity and face value of $1 we can easily calculate
the spot rates as follows:
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Spot Rate : st = P t 1
Case 1 : Finding Yield of Coupon Bond when given Zero Coupon Bond prices
Question : Assume the price of ZCBs are as follows :

Maturity Price
1 0.9615
2 0.9070
3 0.8713

Find the yield of 3 year, 6% coupon bond. Redeemable at par at maturity.

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Solution
Step 1 : Calculate Price of the Bond using the prices of the ZCBs

P = $6(0.9615 + 0.9070 + 0.8713) + $100(0.8713) = $103.5688

Step 2 : Use this price to calculate the yield

$103.5688 = 6a3 + 100v 3

Solution via Newton Rahpson or Excel

1.4 Bootstrapping the Coupon Bond Yield Curve

General Case 1 : Bootstrapping Spot Rates from Coupon Bond Yield Curve
The Case : The following annual coupon bond data is available,

Maturity Coupon Price

1 c1 P1
2 c2 P2
3 c3 P3

The Strategy: This process is known as bootstrapping,

c1 + 1
P1 =
1 + s1
c2 c2 + 1
P2 = +
1 + s1 1 + s2
c3 c3 c3 + 1
P3 = + +
1 + s1 1 + s2 1 + s3
This gives us three equations with three unknowns, which shouldnt be too difficult to solve. Case
2 : Bootstrapping the Yield Curve : Example Question: Find the one and two year spot
rates considering the following bonds,

Maturity Coupon Yield

1 4% 3.5%
2 3% 6%

Solution
First we need to find the prices,
104
P1 = = 99.52 s1 = 4.5%
1.045
The above is possible because we know that for a one year investment the yield is same as the spot
rate by definition.
Finding s2 isnt as simple, firstly we find the price using the yield.
3 103
P2 = + = 94.50
1.06 (1.06)2

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Then we use the definition of the spot rate,
3 103
P2 = 94.50 = +
1 + s1 (1 + s2 )2
103 94.50 1.045
Subbing in s1 , = =
(1 + s2 )2 3
Doing the algebra gives us s2 = 6.023%

1.5 Linking Spot and Forward Rates

The relationship between spot and forward rates is perfectly illustrated by the table and image
below,
PV of $1 at time t is,

Time Spot Rates Forward Rates

1 1
1 (1+s1 ) = 1+f0,1
1 1 1
2 (1+s2 )2
= 1+f0,1 . 1+f1,2
1 1 1 1 1
t (1+st )t = 1+f0,1 . 1+f1,2 . 1+f2,3 1+ft1,t

Deriving Forward Rates from Spot Rates

We use the following general formula,

(1 + st )t
f1t,t = 1
(1 + st1 )t1

Breakdown of above formula is as follows,

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1.6 Practical Complications

In practice the problem is more complicated.

Australian Commonwealth Government Bonds yield quotes on 17 April 2008 (from Bloomberg):

Complication : The coupon months are not evenly spaced. There is no bond maturing every six
months so it is not possible to solve uniquely for different spot rates.

Solution : Fit a yield curve to market data and then extract spot rates from the fitted curve.

1.7 Par Yield

To extract spot rates from the yield curve we make one big assumption which is there are par
bonds. Recall that a Par Bond is a bond that trades at a price equal to the face value (on a coupon
date). On a coupon date, the yield must then be equal to the coupon rate c. Hence,
c c 1+c
1= + 2
+ +
1 + s1 (1 + s2 ) (1 + sn )n

= cv(1) + cv(2) + + (1 + c)v(n)

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We have defined, v(t) = (1+st )t . Rearranging the above expression allows us to solve for c,

1 v(n)
c = Pn
t=1 v(t)

We can use this to extract spot rates.

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1.8 In Continuous Time