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Chapter 4 - Interest Rates

This document summarizes key concepts about interest rates including: 1) It describes different types of interest rates like Treasury rates, LIBOR rates, and repo rates. 2) It explains how to measure interest rates based on compounding frequency and provides examples of converting between continuously compounded and other rates. 3) It outlines how to calculate zero rates, forward rates, bond prices and yields, and the payoffs of forward rate agreements.

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102 views16 pages

Chapter 4 - Interest Rates

This document summarizes key concepts about interest rates including: 1) It describes different types of interest rates like Treasury rates, LIBOR rates, and repo rates. 2) It explains how to measure interest rates based on compounding frequency and provides examples of converting between continuously compounded and other rates. 3) It outlines how to calculate zero rates, forward rates, bond prices and yields, and the payoffs of forward rate agreements.

Uploaded by

uyenbp.a2.1720
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Lecture 3

Interest Rates

Reading: Chapter 4
Hull J. 2013, Fundamentals of futures and options markets, 8th edn., Pearson
Education

1
Types of Rates
• Treasury rates
• LIBORrates
• Repo rates

2
Measuring Interest Rates
• The compounding frequency used for an interest rate is the unit of
measurement
• The difference between quarterly and annual compounding is
analogous to the difference between miles and kilometers

3
Continuous Compounding
(Page 83)

• In the limit as we compound more and more frequently we obtain


continuously compounded interest rates
• $100 grows to $100eRT when invested at a continuously compounded
rate R for time T
• $100 received at time T discounts to $100e-RT at time zero when the
continuously compounded discount rate is R

4
Conversion Formulas
(Page 83)

Define
Rc : continuously compounded rate
Rm: same rate with compounding m times per year

æ Rm ö
R c = m ln ç1 + ÷
è m ø
(
R m = m e R c / m -1 )
5
Zero Rates
Azero rate (or spot rate), for maturity T is the rate of interest earned
on an investment that provides a payoff only at time T

6
Example (Table 4.2, page 85)
Maturity Zero Rate (%
(years) cont. comp.)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

7
Bond Pricing
• To calculate the cash price of a bond we discount each cash flow at
the appropriate zero rate
• In our example, the theoretical price of a two-year bond providing a
6% coupon semiannually is

3 e -0 .0 5 ´0 .5 + 3 e -0 .0 5 81́ .0 + 3 e -0 .0 6 41́ .5
+ 1 0 3 e -0 .0 6 8´2 .0 = 9 8 .3 9

8
Bond Yield
• The bond yield is the discount rate that makes the present value of
the cash flows on the bond equal to the market price of the bond
• Suppose that the market price of the bond in our example equals its
theoretical price of 98.39
• The bond yield is given by solving

to get y = 0.0676 or 6.76% with cont. comp.


3e -y0́.5 + 3e -y1́.0 + 3e -y1́.5 + 103e -y2́.0 = 98.39

9
Forward Rates

The forward rate is the future zero rate implied by today’s term
structure of interest rates

10
Calculation of Forward Rates
Table 4.5, page 89
Year ( n an Zero Rate for Forward Rate
) n -year Investment for n th Year
(% per annum) (% per annum)

1 3.0

2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5

11
Formula for Forward Rates
• Suppose that the zero rates for time periods T1 and T2 are R1 and R2
with both rates continuously compounded.
• The forward rate for the period between times T1 and T2 is

R2 T2 -R1 T1
T2 -T1

12
Forward Rate Agreement
• Aforward rate agreement (FRA) is an agreement that a certain rate
will apply to a certain principal during a certain future time period

13
Forward Rate Agreement (cont.)
• An FRAis equivalent to an agreement where interest at a
predetermined rate, RK is exchanged for interest at the market rate
• An FRAcan be valued by assuming that the forward interest rate is
certain to be realized

14
FRAExample
• Acompany has agreed that it will receive 4% on $100 million for 3
months starting in 3 years
• The forward rate for the period between 3 and 3.25 years is 3%
• The value of the contract to the company is +$250,000 discounted
from time 3.25 years to time zero

15
FRAExample (Cont.)
• Suppose rate proves to be 4.5% (with quarterly compounding
• The payoff is –$125,000 at the 3.25 year point
• This is equivalent to a payoff of –$123,609 at the 3-year point.

16

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