QF2104 Fundamentals of

Quantitative Finance

Dr Chunchun Liu

1
Chapter 2: Financial Instruments &
Term Structure

➢ Money market instrument

➢ Bond
➢ Macaulay duration and modified duration
➢ Yield curves and term structure of interest rate

2
Certificate of Deposit (CD)

A certificate of deposit is a time deposit with a bank that

cannot be withdrawn on demand. It is also called a time

deposit.

➢ A type of savings account offered by banks

3
An example

Questions: Tom invested $20,000 in a CD account with a bank.

The effective annual interest rate was fixed at 5% with a maturity
being 5 years.

(i) Find Tom’s earnings by the time of the maturity.

(ii) If unfortunately, Tom had to withdraw all the money at the end
of the 3rd year. As an early withdraw penalty, To had to pay
half of the interest of the 3rd year. Calculate Tom’s earnings
and penalty charges.

4
Solution

5
Stocks

A share of stock represents an ownership share in the issuing

company. The owner of a share of stock is entitled to receive a
share of the company’s profits in the form of dividends.

6
An example

Questions: A stock is expected to pay dividends at $10 each year

at the end of the year. Assume that the market return is 15%
annually. Calculate the expected stock price.

7
Solution

8
An example

Questions: A stock is expected to pay dividends of $10 next

year. The dividends are expected to grow 3% per year.
Assume that the market return is 15% annually. Calculate
the expected stock price.

9
Solution

10
Commercial Paper

A commercial paper is a short-term unsecured debt note, usually

issued by a large company. It usually lasts one to two months, up
to 270 days. The face amount is most likely in multiples of
$100,000. a commercial paper is the same as a T-bill except that it
is issued by a large corporation instead of a government.

11
An example

Questions: ABC Inc. issued a 90-day, $250,000 commercial paper

on April 18 when the market rate of return was 3.1%. The paper
was sold 49 days later when the market rate of return was 3.63%.
Calculate the price of the commercial paper on its date of issue,
and its date of sale.

12
Solution

13
Commercial Paper

➢ Face value 𝐹 (par value): the amount based on which the

maturity value is paid to the investor at the maturity date
➢ Redemption / maturity value 𝑅 = 𝐹: the amount to be
repaid at the end of the loan
➢ Maturity date 𝑀 (redemption date): the date on which the
loan will be fully repaid
➢ Price 𝑃: the price that the commercial paper are issued
Time (yrs) 0 𝑀

Cash flow −𝑝 𝑅=𝐹

14
Commercial Paper

➢ Yield 𝜆 (nominal):

𝐹/𝑃 − 1
𝜆=
𝑀
where 𝑀 in years (365 days).

➢ This is because we have

𝑃 1+𝜆×𝑀 =𝑅 =𝐹

𝐹/𝑃 −1
Solve for 𝜆, we have 𝜆 = .
𝑀

15
Treasury Bills (T-bills)

Treasury bills (T-bills) are short-term debt instruments issued

(borrowed) by governments.

Government issued bonds are called:

➢ Treasury bills, if maturity is less than one year, non-coupon

bearing

➢ Treasury notes, if maturity is btw 1 year and 10 years,

coupon-bearing

➢ Treasury bonds, if maturity is more than 10 years, coupon-

bearing
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Treasury Bills (T-bills)

Treasury bills are issued at a discount to par value,

have no coupon rate and mature at par value. The
return to the investor is the difference btw the maturity
value and the purchase price.

17
Treasury Bills (T-bills)

➢ Face value 𝐹 (par value): the amount based on which the

maturity value is paid to the investor at the maturity date
➢ Redemption / maturity value 𝑅 = 𝐹: the amount to be
repaid at the end of the loan
➢ Maturity date 𝑀 (redemption date): the date on which the
loan will be fully repaid
➢ Price 𝑃: the price that the T-bills are issued
Time (yrs) 0 𝑀

Cash flow −𝑝 𝑅=𝐹

18
Treasury Bills (T-bills)

➢ Yield 𝜆 (nominal):

𝐹/𝑃 − 1
𝜆=
𝑀
where 𝑀 in years (365 days).

19
An example

Questions: The Canadian government issues a 182-day T-

bill, which has a face value of $100,000. Market yields on
these T-bills are 1.5%. Calculate the price of the T-bill on its
issue date.

20
Solution

21
Bond

Governments or corporations can borrow money by issuing bonds to

investors. A bond is a written contract btw the issuer (borrower) and
the investors (lenders/bond holders) which specifies the following:
➢ Face value 𝐹 (par value): the amount based on which the periodic
interest payments are computed
➢ Redemption / maturity value: the amount to be repaid at the end
of the loan
➢ Maturity date 𝑀 (redemption date): the date on which the loan will
be fully repaid
➢ Coupon rate (for coupon paying bonds): the bond’s interest
payment, as a percentage of the par value, to be made to
investors at regular intervals during the term of the loan
22
Bond

There are various types of bonds: coupon-paying bonds, zero-coupon

bonds, callable bonds, convertible bonds, e.t.c.

Bonds, like stocks, are tradable in financial markets. Fluctuations in

bond prices due to changes in interest rates and failure of bond
issuers to pay coupons (known as bond default) constitute some the
risks bond investors have to face. Other risks include liquidity risk (the
risk of being unable to find a buyer) and reinvestment risk (inability to
invest coupons received at a required rate of return).

In this chapter, we focus primarily on the theory of bond pricing. We

assume that there will be no default risks.

23
Bond Valuations

We shall use the following notations in connection with the bond

pricing formula that follows.

𝑃 = the current price of a bond

𝐹 = face value of a bond

𝑅 = redemption/maturity value of a bond

𝑐 = nominal coupon rate

𝑚 = number of coupon payments per year

𝑛 = total number of coupon payments (number of years times m)

λ = nominal yield

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Bond Valuations

➢ Bond yield λ: the interest rate implied by the payment structure.

Specifically, it is the interest rate at which the present value of the
stream of payments (consisting of a coupon payments and the final
face-value redemption payment) is exactly equal to the current
price.

➢ The bond yield λ is just the internal rate of return of the bond at the
current price.

➢ Yields are always quoted on the annual basis.

25
Bond Valuations

The price of a bond equals to the present value of the

cash flow consisting of all coupon payments and the

redemption value at maturity, calculated at yield λ.

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Bond Valuations

For the case when the cash flow is made up of:

i. Coupon payments of 𝑐𝐹 Τ𝑚 at time 𝑡 = 1Τ𝑚 , 2Τ𝑚 , … , 𝑛Τ𝑚

ii. Redemption/maturity value 𝑅 at 𝑡 = 𝑛Τ𝑚

Time (yrs) 0 1/𝑚 2/𝑚 (𝑛 − 1)/𝑚 n/𝑚

Cash flow −𝑝 𝑐𝐹/𝑚 𝑐𝐹/𝑚 cF/m 𝑐𝐹/𝑚 + 𝑅

We have
𝑛
𝑅 𝑐𝐹/𝑚
𝑃= 𝑛 +෍ 𝑖
𝜆 𝜆
1+ 𝑖=1 1+
𝑚 𝑚
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Bond Valuations

We shall assume that R = 𝐹 unless otherwise stated.

When R = 𝐹,
𝑛
𝑅 𝑐𝐹/𝑚 1 𝑐 1
𝑃= 𝑛 +෍ =F + 1−
𝜆 𝜆 𝑖 𝜆 𝑛 𝜆 𝜆 𝑛
1+ 𝑖=1 1+ 1+ 1+
𝑚 𝑚 𝑚 𝑚
The above formula can also be written as

𝑐−𝜆 1
𝑃 =𝐹+𝐹 1− 𝑛
𝜆 𝜆
1+
𝑚

28
Bond Valuations

From the bond pricing formula

𝑐−𝜆 1
𝑃 =𝐹+𝐹 1− 𝑛
𝜆 𝜆
1+
𝑚
it is easily seen that

i. 𝑃 > 𝐹 if and only if 𝑐 > λ

ii. 𝑃 = 𝐹 if and only if 𝑐 = λ

iii. if 𝑃 < 𝐹 if and only if 𝑐 < λ

29
Bond Valuations

A bond is said to be priced

i. at a premium if 𝑃 > 𝐹 (iff 𝑐 > λ)

ii. at par if 𝑃 = 𝐹 (iff 𝑐 = λ)

iii. at a discount if 𝑃 < 𝐹 (iff 𝑐 < λ)

30
Bond Valuations

𝐹
If we let 𝐾 = 𝜆 𝑛
, then we have the following Makeham Formula:
1+
𝑚

𝑐
𝑃 = 𝐾 + (𝐹 − 𝐾)
𝜆

31
An example

Questions: A 10-year bond with face value $100 pays coupons

semi-annually at an nominal annual rate of 6%, and its redeemable
at face value. Find the bond price if the effective annual bond yield
is 8%.

32
Solution

33
An Example

Question: A 20-year bond with face value $100 pays coupons

semi-annually at an nominal (annual) rate of 9% , and is
redeemable at face value. Find the bond price if the nominal bond
yield is 12% convertible semi-annually

34
Solution

35
An Example

Question: A 30-year bond of face value 100 pays coupons

semi-annually. The nominal coupon rate for this bond is 4%
for the first 10 years, 6% for the next 10 years, and 8% for
the last 10 years. If the nominal bond yield is 6%, find the
price of the bond.

36
Solution

37
Bond Valuations

Let 𝑃𝑘 be the price immediately after the kth coupon payment, then

𝜆
𝑃𝑘+1 = 𝑃𝑘 1+ − 𝑐𝐹/𝑚
𝑚

This is because
𝑛−𝑘
𝐹 𝑐𝐹/𝑚
𝑃𝑘 = +෍
(1 + λΤ𝑚)𝑛−𝑘 (1 + λΤ𝑚)𝑖
𝑖=1
𝑛−𝑘−1
𝐹 𝑐𝐹/𝑚
𝑃𝑘+1 = + ෍
(1 + λΤ𝑚)𝑛−𝑘−1 (1 + λΤ𝑚)𝑖
𝑖=1

𝜆 𝑐𝐹 𝜆 𝑐𝐹
So 1 + 𝑃𝑘 = 𝑃𝑘+1 + ⇒ 𝑃𝑘+1 = 1 + 𝑃𝑘 −
𝑚 𝑚 𝑚 𝑚

38
An example

Questions: A five-year bond with face value $100 pays

semiannual coupons at a coupon rates of 8%, The bond is priced
to yield 6% compounded semi-annually. Find the bond price as of
the settlement date, as of the end if the 3rd year, and as of the
end of 3.5 years.

39
Solution

40
More Bonds

Zero coupon bonds: these are bonds that pay no coupons. The cash
flow of a 𝑁-year-zero-coupon bond is the maturity value, 𝑅 at 𝑡 = 𝑁.
Hence at an annual yield of λ,

𝑅
𝑃=
(1 + λ)𝑁

Perpetual bonds: these are bonds that are never mature (i.e. 𝑛 → ∞).
Clearly, we have

𝑐𝐹
𝑃=
λ
41
Determining Bond Yield

In practice, the bond price is used to solve for bond yield, which is
the internal rate of return of the cash flow induced by the bond.
Due to the complexity of the equation of value, numerical methods
are usually employed to approximate the yield.

Price-yield relationship: a fundamental property of bond pricing

formula is that P is a decreasing function of λ. Furthermore, it can
be shown that the graph of the price-yield curve is convex.

42
The Price-Yield Curve

The diagram shows a typical

price-yield curve. Note that
the maximum possible bond
price is attained when the
yield is zero, in which case
the cash flow stream is
undiscounted, that is, the
maximum bond price is the
sum of all coupon payments
and the par value.
43
The Price-Yield Curve

Given
𝑛
𝑐𝐹/𝑚 𝑅
𝑃=෍ 𝑖
+ 𝑛
𝜆 𝜆
𝑖=1 1+ 1+
𝑚 𝑚
by direct calculation, we have
𝑛 𝑐𝐹
′ 𝑚 𝑖 𝑅 𝑛
𝑃 𝜆 =෍ 𝑖+1
− + 𝑛+1 − <0
𝜆 𝑚 𝜆 𝑚
𝑖=1 1 + 1+
𝑚 𝑚
𝑛 𝑐𝐹
′′ 𝑚 𝑖 𝑖+1 𝑅 𝑛 𝑛+1
𝑃 𝜆 =෍ 𝑖+2
− − + 𝑛+2 − − >0
𝜆 𝑚 𝑚 𝜆 𝑚 𝑚
𝑖=1 1 + 1+
𝑚 𝑚

44
An Example

Question: A n-year bond with face value F is redeemable at par and

pays coupons annually at a rate of c. At a price of P, the bond yield is r.
𝑃−𝐹
Let 𝛼 = .
𝐹

i. Use the Taylor series approximation formula 𝑓 𝑟 ≈ 𝑓 0 +

′ 𝑟2
𝑓 0 𝑟+ 𝑓′′(0) to show that for small r, (1 + 𝑟)−𝑛 ≈ 1 − 𝑛𝑟 +
2!
𝑛 𝑛−1
𝑟2
2

ii. Use the bond pricing formula and the result in (i) to show that
𝑛+1 𝑎
1− 𝑟 𝑐−𝑟 =
2 𝑛

45
An Example

iii. A 10-year bond with face value 100 is redeemable at par and pays
coupons annually at 4%. Given that the bond is priced at 90, use
the equation in (ii) to find an approximation value of the bond yield
(round to 3 decimal places). Hint: you may assume that the actual
bond yield is between 4% to 6%.

46
Solution

47
Yield Curves

Bond yield varies with term to maturity. At the point in time, the

relationship btw yield (interest rate) and maturity is called the term

structure of interest rates.

48
An Example
The hypothetical table of yields below was constructed from 10 bonds of
different maturities, each paying annual coupons:
Maturity (in years) Annual coupon rate Effective annual yield

1 2.000% 5.000%
2 5.500% 5.487%
3 5.961% 5.961%
4 11.000% 6.293%
5 3.000% 6.651%
6 14.000% 6.776%
7 0.000% 7.250%
8 7.500% 7.276%
9 4.000% 7.536%
10 8.000% 7.582%
Question. In the above table, compute the price of the 1-year bond, 2-year
bond, and 3-year bond, for which 𝑅 = 𝐹 = 100. 49
Solution

50
Yield Curves

The of a bond’s yield against the bond’s time to maturity is called a

yield curve. The yield curve for our 10 bonds in the previous example

is as follows:

51
Yield Curves

The shape of a yield curve varies over time. The most commonly observed
yield curve shape is upward-sloping, or normal. This pattern is normally
observed during periods of economic expansions and when inflation pressure
is low. A yield curve is said to be inverted if it is downward sloping. Inverted
yield curves are rare. They are usually observed during or just before
recessionary periods or when inflation pressure is high. Yield curves can be
drawn for various types of bonds: Treasury-bonds backed by the U.S.
government, corporate bonds issued by corporations, etc. Typically, yield
curves based on non-Treasury bonds lie above Treasury yield curves.

52
Yield Curves

53
Spot and Forward Rates

A spot rate is the (annual) interest rate that begins today (𝑡 = 0)

and lasts until some future time 𝑡. We denote this rate by 𝑠𝑡 . In
effect, the spot rate 𝑠𝑡 is the yield to maturity of a zero-coupon
bond that matures at 𝑡. A spot rate curve (or spot yield curve) is a
plot of spot rates against time to maturity.

The interest rate observed at some future time 𝑡1 > 0 and lasts until
a time 𝑡2 > 𝑡1 is called a forward rate, denoted by 𝑓𝑡1 𝑡2 . Note that
𝑓0𝑡 = 𝑠𝑡 .
54
Spot Rate and Forward Rate

To illustrate some basic relationship btw spot rates and

forward rates, we divide the time line into equally spaced
periods [𝑖 − 1, 𝑖] for 𝑡 = 1,2,3, …, and write 𝑠𝑗 and 𝑓𝑗,𝑘 for the
spot rate and forward rate respectively.

55
Spot Rate and Forward Rate

A basic relationship between spot rate and forward rate is

𝑘 𝑗 𝑘−𝑗
1 + 𝑠𝑘 = 1 + 𝑠𝑗 1 + 𝑓𝑗,𝑘

We can deduce that

1 + 𝑠𝑛 𝑛 = 1 + 𝑠1 1 + 𝑓1,2 1 + 𝑓2,3 … (1 + 𝑓𝑛−1,𝑛 )

Given a term structure {𝑠1 , 𝑠2 , … , 𝑠𝑛 }, the forward rate 𝑓𝑖,𝑗 where

1 ≤ 𝑖 < 𝑗 ≤ 𝑛 can be determined.

56
Determining Spot Rate

From the valuation formula of a n-year zero-coupon bond:

𝐹
𝑃=
(1 + 𝑠𝑛 )𝑛
we get
𝐹 1/𝑛
𝑠𝑛 = ( ) −1
𝑃
This gives us an equation relating yield and time to maturity.
However, prices of zero-coupon bonds of specific time may not
always be available. To determine spot rates when no appropriate
zero-coupon bonds can be found, we can apply the Bootstrap
Method to appropriate coupon-paying bonds.

57
Bootstrap Method

Suppose 𝑠1 , 𝑠2 ,…, 𝑠𝑛−1 have already been determined. To estimate

𝑠𝑛 , we consider a n-period coupon-paying bond with cash flows
(−𝑃𝑛, 𝑐𝐹, 𝑐𝐹, … , 𝑐𝐹 + 𝐹). From the pricing formula,

𝑐𝐹 𝑐𝐹 𝑐𝐹 𝑐𝐹 + 𝐹
𝑃𝑛 = + 2
+ ⋯+ 𝑛−1
+
(1 + 𝑠1 ) 1 + 𝑠2 1 + 𝑠𝑛−1 1 + 𝑠𝑛 𝑛

𝑠𝑛 can be determined.

58
An Example

Question: the maturity and prices of two zero-coupon bonds, each

having a face value of $100, are given in the table below
One-year Two-year
$90 $80

Find:

i. The forward interest rate 𝑓1,2 implied by these bonds

ii. The price of a two-year bond that pays 5% coupon annually.

59
Solution

60
An Example

Question: An one-year bond with annual coupon of $6 and par value

$100 is trading at $102.91. A two-year bond with annual coupon of
$6.5 and par value $100 is priced at $101.10. Compute the one-year
spot interest rate and two-year spot interest rate.

61
Solution

62
An Example

Question: The term structure for the next 5 years is found to be

(s1, s2, s3, s4, s5 ) = (4%, x%, 5%, 5.3%, y %)
The forward rate 𝑓2,3 = 3.9%. A five-year bond (face value 100) that
pays 5% annual coupons and is redeemable at par is priced at 98.
find to 3 significant figures:

(i) the forward rate 𝑓1,4 ; (ii) the value of x; (iii) the value of y; (iv) the
price of a 4-year-zero-coupon bond of face value 100; (v) the price of
a 3-year-bond (face value 100) that pays 4% coupon annually and
can be redeemed at 102.

63
Solution

64