Module 2:

Interest rates, Determinationof forward and futures prices

TYPES OF RATES:

An interest rate in a particular situation defines the amount of money a borrower

promises to pay the lender. For any given currency, many different types of interest rates are
regularly quoted. These include mortgage rates,(mortgage is a contractual agreement between
a borrower and a lender, where the lender has the right to claim the borrower's property if the
borrower fails to repay the borrowed amount along with interest. Mortgages are primarily
used for purchasing a home or leveraging the value of an existing home to borrow
money.)(Most consumers require a mortgage in order to finance the purchase of a home or
other piece of property. Under a mortgage agreement, the borrower agrees to make regular
payments to the lender for a specific number of years until the loan is either repaid in full or
it is refinanced. The mortgage payment includes a principal portion plus interest. Mortgage
interest is charged for both primary and secondary loans, home equity loans, lines of credit
(LOCs), and as long as the residence is used to secure the loan.As mentioned above,
mortgage interest is calculated as a certain percentage of the mortgage loan. Some
mortgages come with fixed-interest rates while others have variable interest rates.
deposit rates, The deposit rate is the interest rate paid by commercial banks or
financial institutions on cash deposits of account holders. Deposit accounts include
certificates of deposit (CD), savings accounts, and other investment accounts.Financial
institutions encourage long-term deposits not only for the client’s benefit from the extended
interest that is garnered, but because it offers more liquidity to the institution. By having
more cash on deposit, an institution can make more lending transactions, such as loans and
credit cards, available to its customers.
prime borrowing rates, and so on. The interest rate applicable in a situation depends
on the credit risk. This is the risk that there will be a default by the borrower of funds, so that
the interest and principal are not paid to the lender as promised. The higher the credit risk, the
higher the interest rate that is promised by the borrower.
Interest rates are often expressed in basis points. One basis point is 0.01% per annum.

• Treasury Rates
• LIBOR
• The Fed Funds Rate
• Repo Rates
• The ‘‘Risk-Free’’ Rate

Treasury rates:
Treasury rates are the rates an investor earns on Treasury bills and Treasury bonds.
These are the instruments used by a government to borrow in its own currency. Japanese
Treasury rates are the rates at which the Japanese government borrows in yen; US Treasury
rates are the rates at which the US government borrows in US dollars; and so on. It is usually
assumed that there is no chance that a government will default on an obligation denominated
in its own currency. Treasury rates are therefore totally risk-free rates in the sense that an
investor who buys a Treasury bill or Treasury bond is certain that interest and principal
payments will be made as promised.
LIBOR:
LIBOR is short for London Interbank Offered Rate. It is an unsecured short-term
borrowing rate between banks. LIBOR rates have traditionally been calculated each business
day for 10 currencies and 15 borrowing periods. The borrowing periods range from one day
to one year. LIBOR rates are used as reference rates for hundreds of trillions of dollars of
transactions throughout the world. One popular derivatives transaction that uses LIBOR as a
reference interest rate is an interest rate swap. LIBOR rates are published by the British
Bankers Association (BBA)at 11:30 a.m. (UK time). The BBA asks a number of different
banks to provide quotes estimating the rate of interest at which they could borrow funds just
prior to 11:00 a.m. (UK time). The top quarter and bottom quarter of the quotes for each
currency/ borrowing-period combination are discarded and the remaining ones are averaged
to determine the LIBOR fixings for a day. Typically the banks submitting quotes have a AA
credit rating.(The best credit rating category is AAA. The second best is AA) LIBOR is
therefore usually considered to be an estimate of the shortterm unsecured borrowing rate for a
AA-rated financial institution.
In recent years there have been suggestions that some banks may have manipulated
their LIBOR quotes. Two reasons have been suggested for manipulation. One is to make the
banks’ borrowing costs seem lower than they actually are, so that they appear healthier.
Another is to profit from transactions such as interest rate swaps whose cash flows depend on
LIBOR fixings. The underlying problem is that there is not enough interbank borrowing for
banks to make accurate estimates of their borrowing rates for all the different
currency/borrowing-period combinations that are used. It seems likely that over time the
large number of LIBOR quotes that have been provided each day will be replaced by a
smaller number of quotes based on actual transactions in a more liquid market.

The Fed Funds Rate:

In the United States, financial institutions are required to maintain a certain amount of
cash (known as reserves) with the Federal Reserve. The reserve requirement for a bank at any
time depends on its outstanding assets and liabilities. At the end of a day, some financial
institutions typically have surplus funds in their accounts with the Federal Reserve while
others have requirements for funds. This leads to borrowing and lending overnight. In the
United States, the overnight rate is called the federal funds rate. A broker usually matches
borrowers and lenders. The weighted average of the rates in brokered transactions (with
weights being determined by the size of the transaction) is termed the effective federal funds
rate. This overnight rate is monitored by the central bank, which may intervene with its own
transactions in an attempt to raise or lower it. Other countries have similar systems to the US.
For example, in the UK the average of brokered overnight rates is termed the sterling
overnight index average (SONIA) and, in the euro zone, it is termed the euro overnight index
average (EONIA).
Both LIBOR and the federal funds rate are unsecured borrowing rates. On average,
overnight LIBOR has been about 6 basis points (0.06%) higher than the effective federal
funds rate except for the tumultuous period from August 2007 to December 2008. The
observed differences between the rates can be attributed to timing effects, the composition of
the pool of borrowers in London as compared to New York, and differences between the
settlement mechanisms in London and New York.

Repo Rates:
Unlike LIBOR and federal funds rates, repo rates are secured borrowing rates. In a
repo (or repurchase agreement), a financial institution 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. The interest
rate is referred to as the 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. However, longer term arrangements, known as
term repos, are sometimes used. Because they are secured rates, a repo rate is generally
slightly below the corresponding fed funds rate.

The ‘‘Risk-Free’’ Rate:

Derivatives are usually valued by setting up a riskless portfolio and arguing that the
return on the portfolio should be the risk-free interest rate. The risk-free interest rate therefore
plays a key role in the valuation of derivatives. Here we will refer to the ‘‘risk-free’’ rate
without explicitly defining which rate we are referring to. This is because derivatives
practitioners use a number of different proxies for the riskfree rate. Traditionally LIBOR has
been used as the risk-free rate—even though LIBOR is not risk-free because there is some
small chance that a AA-rated financial institution will default on a short-term loan. However,
this is changing.

MEASURING INTEREST RATES:

A statement by a bank that the interest rate on one-year deposits is 10% per annum
sounds straightforward and unambiguous. In fact, its precise meaning depends on the way the
interest rate is measured.
If the interest rate is measured with annual compounding, the bank’s statement that
the interest rate is 10% means that $100 grows to
$100 * 1.1 = $110
at the end of 1 year. When the interest rate is measured with semiannual compounding, it
means that 5% is earned every 6 months, with the interest being reinvested. In this case, $100
grows to
$100 * 1.05 * 1:05 = $110.25
at the end of 1 year. When the interest rate is measured with quarterly compounding, the
bank’s statement means that 2.5% is earned every 3 months, with the interest being
reinvested. The $100 then grows to
$100 *(1.025)4 = $110:38
at the end of 1 year. Following table shows the effect of increasing the compounding
frequency further.
 The compounding frequency defines the units in which an interest rate is measured. A
rate expressed with one compounding frequency can be converted into an equivalent rate
with a different compounding frequency. For example, from above table, we see that 10.25%
with annual compounding is equivalent to 10% with semiannual compounding. We can think
of the difference between one compounding frequency and another to be analogous to the
difference between kilometers and miles. They are two different units of measurement.
To generalize our results, suppose that an amount A is invested for n years at an
interest rate of R per annum. If the rate is compounded once per annum, the terminal value of
the investment is
A(1 + R)n
If the rate is compounded m times per annum, the terminal value of the investment is
A(1 + R/m)mn (eq 1)

When m = 1, the rate is sometimes referred to as the equivalent annual interest rate.

Continuous Compounding:
The limit as the compounding frequency, m, tends to infinity is known as continuous
compounding. (Actuaries sometimes refer to a continuously compounded rate as the force of
interest.) With continuous compounding, it can be shown that an amount A invested for n
years at rate R grows to
AeRn (eq2)
Where, e is approximately 2.71828.

In the example in above table, A = 100, n = 1, and R = 0.1, so that the value to which A
grows with continuous compounding is
100e0.1 = $110.52
This is (to two decimal places) the same as the value with daily compounding.

For most practical purposes, continuous compounding can be thought of as being

equivalent to daily compounding.
• Compounding a sum of money at a continuously compounded rate R for n years
involves multiplying it by eRn.
• Discounting it at a continuously compounded rate R for n years involves multiplying
by e -Rn.
Suppose that Rc is a rate of interest with continuous compounding and Rm is the
equivalent rate with compounding m times per annum. From the results in equations (1) and
(2), we have

(eq3)

(eq 4)
These equations can be used to convert a rate with a compounding frequency of m times per
annum to a continuously compounded rate and vice versa. The natural logarithm function ln
x, which is built into most calculators, is the inverse of the exponential function, so that, if y
= ln x, then x = ey.

Example 1
Consider an interest rate that is quoted as 10% per annum with semiannual compounding.
Calculate equivalent rate with continuous compounding.
Soluton: From equation (3) with m = 2 and Rm = 0:1, the equivalent rate with continuous
compounding is
2 ln(1 + 0.1/2) = 0:09758
or 9.758% per 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. Calculate equivalent rate with
quarterly compounding. Also calculate interest payment on $1000 each quarter.
Solution: From equation (4) with m = 4 and Rc = 0:08, the equivalent rate with quarterly
compounding is
4 *(e0:08/4 – 1) = 0:0808
or 8.08% per annum.
This means that on a $1,000 loan, interest payments of $20.20 would be required each
quarter.

ZERO RATES:
The n-year zero-coupon interest rate is the rate of interest earned on an investment
that starts today and lasts for n years. All the interest and principal is realized at the end of n
years. 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-yearzero.

Example: Suppose a 5-year zero rate with continuous compounding is quoted as 5% per
annum. This means that $100, if invested for 5 years, grows to
AeRn = 100 * e0:05*5 = 128.40
Most of the interest rates we observe directly in the market are not pure zero rates.
Consider a 5-year government bond that provides a 6% coupon. The price of this bond does
not by itself determine the 5-year Treasury zero rate because some of the return on the bond
is realized in the form of coupons prior to the end of year 5.

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 calculated as the present value of all the cash flows that will be received by the
owner of the bond. Sometimes bond traders use the same discount rate for all the cash flows
underlying a bond, but a more accurate approach is to use a different zero rate for each cash
flow.
To illustrate this, consider the situation where Treasury zero rates, measured with
continuous compounding, are as given in following table.
Suppose that a 2 year Treasury bond with a principal of $100 provides coupons at the rate of
6% per annum semiannually. To calculate the present value of the first coupon of $3, we
discount it at 5.0% for 6 months; to calculate the present value of the second coupon of $3,
we discount it at 5.8% for 1 year; and so on.
Therefore, the theoretical price of the bond is

or $98.39.

Bond Yield:
A bond’s yield is the single discount rate that, when applied to all cash flows, gives a bond
price equal to its market price. Suppose that the theoretical price of the bond we have been
considering, $98.39, is also its market value (i.e., the market’s price of the bond is in exact
agreement with the data in Table given above). If y is the yield on the bond, expressed with
continuous compounding, it must be true that

This equation can be solved using an iterative (‘‘trial and error’’) procedure to give
y = 6.76%.

(One way of solving nonlinear equations of the form f(y) = 0, such as this one, is to use the
Newton–Raphson method. We start with an estimate y0 of the solution and produce
successively better estimates y1, y2, y3, . . . using the formula
Yi+1 = yi – f(yi)/f’(yi),
where f’(y) denotes the derivative of f with respect to y.)

Par Yield:
The par yield for a certain bond maturity is the coupon rate that causes the bond price to equal its par
value. (The par value is the same as the principal value.) Usually the bond is assumed to provide semiannual
coupons.
Suppose that the coupon on a 2-year bond in our example is c per annum (or ½ * c per 6 months).
Using the zero rates in Table given above, the value of the bond is equal to its par value of 100 when

This equation can be solved in a straightforward way to give c = 6.87. The 2-year par yield is therefore
6.87% per annum. This has semiannual compounding because payments are assumed to be made every 6
months. With continuous compounding, the rate is 6.75% per annum.
More generally, if d is the present value of $1 received at the maturity of the bond, A is the value of
an annuity that pays one dollar on each coupon payment date, and m is the number of coupon payments per
year, then the par yield c must satisfy,
DETERMINING TREASURY ZERO RATES:
One way of determining Treasury zero rates such as those in above Table is to observe the
yields on ‘‘strips.’’ These are zero-coupon bonds that are synthetically created by traders when they sell
coupons on a Treasury bond separately from the principal.
Another way to determine Treasury zero rates is from Treasury bills and coupon bearing bonds. The
most popular approach is known as the bootstrap method. To illustrate the nature of the method, consider the
data in following table on the prices of five bonds. Because the first three bonds pay no coupons, the zero
rates corresponding to the maturities of these bonds can easily be calculated. The 3-month bond has the effect
of turning an investment of 97.5 into 100 in 3 months. The continuously compounded 3-month rate R is
therefore given by solving