Modeling of Bonds, Term Structure,

and Interest Rate Derivatives

Variable Interest Rates

Lectures Delivered
in Course FM-14 at M. Sc. Financial Mathematics course,
At Dept. of Applied Mathematics

V. D. Pathak

Retired Professor,
Department of Applied Mathematics,
Faculty of Technology & Engineering
The M.S. University of Baroda
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 FM-14: Syllabus
Bonds and Term Structure
• The concept of the term structure of interest rates.
Presentation of theories explaining the shapes of the term
structure encountered in practice. Methods of
constructing long horizon term structure (bootstrapping,
presentation of  STRIPS).
• Tools describing dynamics of bond prices: yields, forward
rates, short (instantaneous) rates. Money market
account.
• Risk management in case of parallel shift. Applications of
duration and convexity for immunization of bond
portfolios. Problems with non-parallel shifts of term
structure and tools necessary in this case.

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 FM-14: Syllabus
• Necessity of developing a theory of random interest rates.
Construction of Binomial trees for bond prices, yields and
forward rates. No arbitrage principle and its consequences
concerning admissible models. Risk neutral probabilities
and a theorem on their dependence on maturity.
• Presentation of a variety of short term models (Vasicek,
CIR, Dothan, Brennan-Schwartz). Single factor and multi-
factor models. Model calibration. Discrete and continuous
time versions.
• Outline of term structure models (Ho-Lee, Black-Derman-
Toy, Hull-White) in discrete and continuous time framework.
Forward rate model of Heath-Jarrow-Morton. Some other
recent models (Brace-Gatarek-Musiela)

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 FM-14: Syllabus
• Interest Rate Derivatives
• Derivative securities in models with random interest rates.
Pricing options.
• Pricing and hedging interest rate futures, caps, floors, collars,
swaps, caplets, florlets, swaptions.
• References:
• M. Capiński and T. Zastawniak, Mathematics for Finance,
Chapters 10, 11. Springer-Verlag, London 2003.
• R. Jarrow, Modelling Fixed Income Securities and Interest
Rate Options, McGraw-Hill, New York 1996.
• T. Bjork, Arbitrage Theory in Continuous Time, Oxford
University Press, Oxford 1998.

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 Zero Coupon Bonds
Definition 1: A zero coupon bond with maturity date T, also
called a T-bond, is a contract which guarantees the holder 1
dollar to be paid on the date T.
• The price at time t of a bond with maturity date T is
denoted by B(t, T).
• The convention that the payment at the time of maturity,
known as the principal value or face value, equals one is
made for computational convenience.
• Coupon bonds, give the owner a payment stream during
the interval [0, T].
• These instruments have the common property, that they
provide the owner with a deterministic cash flow, and for
this reason they are also known as fixed income
instruments.
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 A sufficiently rich and regular bond market
Assumptions to guarantee the existence of a
andand
sufficiently rich regular bond
regular bondmarket.
market.
• There exists a (frictionless) market for T-bonds for
every T > 0.
• The relation B(t, t) = 1 holds for all t (to avoid
arbitrage). 

Assumption on Time variation: Time is considered as

a discrete variable with fixed time step τ , writing t =
τn for the running time and T = τN for the maturity
time. In the majority of examples we shall take either
τ = 1/12 or τ = 1. The notation B(n, N) will be
employed instead of B(t, T) for the price of a zero-
coupon unit bond.
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 Maturity-Independent Yields
The present value (at t = 0, i.e. B(0, N) of a zero-
coupon unit bond determines an interest rate called
the yield and denoted by y(0) to emphasize that it is
computed at time 0. At present time B(0, N) is known
and we compute yield y(0) such that when
compounded continuously, B(0, n) will grow to value
1, the value of the bond at T = Nτ. That is
B(0, N) = e−Nτy(0).
In other words B(0, N) is present value of $1.
For a different running time instant n such that 0 < n
< N the implied yield may in general be different from
y(0).
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 Maturity-Independent Yields
For each such n we thus have a number y(n)
satisfying B(n, N) = e−(N−n)τ y(n) .
Generally (and in most real cases), a bond with
different maturity N will imply a different yield.
Nevertheless, initially (unless mentioned otherwise
later) we consider the simplified situation when y(n) is
independent of N, that is, bonds with different
maturities generate the same yield.
Since the value of a bond at any time t > 0 (or n > 0)
is not known at time 0, y(n) is also not known at 0, in
general. What happens if y(n) for some n > 0 is
known at time 0?

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 Maturity-Independent Yields
Proposition 1: If the yield y(n) for some n > 0 were
known at time 0, then y(0) = y(n) or else an arbitrage
strategy could be found.
Proof: Case 1: Suppose that y(0) < y(n).
At t = 0: (i)Borrow a dollar for the period [0, n + 1].
(ii) Deposit it for the period [0, n], both at the rate
y(0). (The yield can be regarded as the interest rate
for deposits and loans.)
At time n: (i) withdraw the deposit with interest, get
total amount enτ y(0).
(ii) Invest this sum for a single time step @ y(n).
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 Proof of Proposition 1 continued
At time n + 1 this brings enτ y(0)+τ y(n) . The initial loan requires
repayment of e(n+1)τ y(0), leaving a +ve balance enτ y(0) (eτy(n) −
eτy(0)), which is the arbitrage profit.
Case 2: Suppose y(0) > y(n):
At t = 0: (i) Borrow a dollar for the period [0, n].
(ii)Deposit it for the period [0, n+1], both at the rate y(0).
At time n: Borrow enτy(0) amount for single time step.
And repay the earlier loan.
At time (n+1): Initial deposit with interest gives you amount
e(n+1)τ y(0) and we have to repay new loan by paying amount
enτy(0)+ τy(n), leaving a +ve balance enτ y(0) (eτy(0) − eτy(n)),
which is the arbitrage profit.
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 Maturity-Independent Yields - illustration
Example 1: Let τ = 1 /12 . Find arbitrage if the yields
are independent of maturity, and unit bonds maturing
at time 6 (half a year) are traded at B(0, 6) = 0.9320
dollars and B(3, 6) = 0.9665 dollars, both prices being
known at time 0.
Solution: 0.9320 = B(0, 6) = e-Nτy(0) = e-0.5y(0)
Therefore y(0) = - 2 x ln 0.9320 = 0.141.
o.9665 = B(3, 6) = e−(N−n)τ y(n) = e-0.25y(3)
Therefore y(3) = - 4 x ln 0.9665 = 0.136
Since y(0) > y(3), Arbitrage profit = enτy(0)(e3τy(0) − e3τy(n))
= e0.25 x 0.141 (e0.141x3/12 − e0.136x3/12) = 1.036x 0.0014 =
0.00145.
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 Other solution
The yields are y(0) ∼= 14.08% and y(3) ∼= 13.63%.
Thus B(0, 3) = e−3τy(0) ∼= 0.9654 dollars. Arbitrage can be
achieved as follows:
• At time 0: buy a 6-month bond for B(0, 6) = 0.9320 dollars,
raising the money by issuing 0.9654 of a 3-month bond, which
sells at B(0, 3) ∼= 0.9654 dollars.
• At time 3 (after 3 months) issue 0.9989 of a 6-month bond,
which sells at B(3, 6) = 0.9665 dollars, and use the proceeds of
$0.9654 to settle the fraction of a 6-month bond issued at time
0.
• At time 6 (after half a year) the 6-month bond bought at time 0
will pay $1, out of which $0.9989 will settle the fraction of a 3-
month bond issued at time 3. The balance of $0.0011 will be the
arbitrage profit.
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 Maturity-Independent Yields
Remarks: 1. As a consequence of Proposition 1, if the
yield is independent of maturity and deterministic (that
is, y(n) is known in advance for any n ≥ 0), then it
must be constant, y(n) = y for all n.
2. Historical bond prices show a different picture: The
yields implied by the bond prices recorded in the past
clearly vary with time. In an arbitrage-free model, to
admit yields varying with time but independent of
maturity we should allow them to be random.
3. We assume, therefore, that at each time instant the
yield y(n) is a positive random number independent of
the maturity of the underlying bond.

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 Investment in Single Bonds
Suppose we invest in bonds for a period of six months.
Let τ = 1/12 . We buy a number of unit bonds that will
mature after one year, paying B(0, 12) = 0.9300 for
each.
Therefore, y(0) ∼= -ln (0.93) = 7.26%.
Since we are going to sell the bonds at time n = 6, we are
concerned with the price B(6, 12) or, equivalently, with
the corresponding rate y(6). Let us discuss some possible
scenarios:
1. The rate is stable, y(6) = 7.26%. The bond price is B(6,
12) ∼= e-0.5 x .0726 = 0.9644.
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 Investment in Single Bonds
and the logarithmic return on the investment is:
= ln (0.9644 / 0.93) = 3.63% a half of 7.26%, in line
with the additivity of logarithmic returns.
2. The rate decreases to 6.26% (Drop by 100 basic
points). Then B(6, 12) = e-0.5 x .0626 = 0.9692, giving
logrithemic return = ln (0.9692 / 0.93) = 4.13%
3. Rate increases to 8.26%, Then
B(6, 12) = e-0.5 x .0826 = 0.9595, giving logrithemic return
= ln (0.9595 / 0.93) = 3.12%
We can see a pattern here: One is better off if the rate
drops and worse off if the rate increases.
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 Computing Logarithmic Return
Suppose that the initial yield y(0) changes randomly to
become y(n) ≠ y(0) at time n. Hence B(0, N) = e−y(0)τN,
B(n, N)=e−y(n)τ(N−n), and the logarithmic return on an
investment closed at time n (for period [0, n]) will be:
k(0, n) = ln (B(n,N) / B(0,N)) = ln (ey(0)τN−y(n)τ(N−n))
= y(0)τN − y(n)τ(N − n).
Remark: Investment of B(0, N) becomes B(n, N) over
a period [0, n]. Assumption of continuous
compounding implies that if return on entire period is
k(0, n) then B(n, N) = B(0, n) x ek(0, n).
For example, in 3rd case,
K(0,6) = .0726 - .0826 x 0.5 = .0313 i.e. 3.13%
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 Logarithmic Return - illustrations
Example 2: Let τ = 1/12. Invest $100 in six-month
zero-coupon bonds trading at B(0, 6) = 0.9400 dollars.
After six months reinvest the proceeds in bonds of the
same kind, now trading at B(6, 12) = 0.9368 dollars.
Find the implied interest rates and compute the
number of bonds held at each time. Compute the
logarithmic return on the investment over one year.
Solution: Get 100/0.94 =106.38 bonds at t = 0.
After 6 months we get 106.38 invest it in 12 months
bond @ 0.9368. we get 113.56 bonds.
K(0, 6) = ln (1.0638) = 6.18%; k(6, 12) = 6.53%
K(0, 12) = ln (1.1356) = 12.72%
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 Logarithmic Return - illustrations

Example 3: Suppose that B(0, 12) = 0.8700 dollars.

What is the interest rate after 6 months if an
investment for 6 months in zero-coupon bonds gives
a logarithmic return of 14% ?
After 6 months we get 0.87 x e0.14 = 1.0007
Which is impossible.
Hint: In general to find y(6) Solve: B(0, 12)ek = e−τy(6)
(In order to get positive yield, LHS must be less than
one).

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 Logarithmic Return - illustrations
Example 4: τ = 1/360 . (A year is assumed to have
360 days here.) Suppose that B(0, 360) = 0.9200
dollars, the rate remains unchanged for the first six
months, goes up by 200 basis points on day 180, and
remains at this level until the end of the year. If a bond
Logarithmic Return -
is bought at the beginning of the year, on which day
illustrations
should it be sold to produce a logarithmic return of
4.88% or more?
Solution: During the first six months the rate is
y(0) ∼= ln (1 / 0.92) = 8.34%, for n = 0,..., 179, and
during the rest of the year y(n) ∼= 10.34%, for n =
180,..., 360.
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 How to replicate such a cash flow?
The bond should be sold for 0.92e0.0488 ∼= 0.9660
dollars or more. This cannot be achieved during the
first six months, since the highest price before the rate
changes is B(179, 360)∼= 0.92e0.0834x179/360 = 0.9589$
On the day of the rate change
B(180, 360) = e-0.1034x180/360 = 0.9496$
Find n such that 1.0 x e –((360-n)/360)x 0.1034 = 0.966
we have to wait until day n = 240, on which the bond
price will exceed the required $0.9660 for the first
time.
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 An investment in coupon bonds
A coupon bond is kept to maturity, however, the
coupons are paid in the meantime and can be
reinvested. The return on such an investment
depends on the interest rates prevailing at the times
when the coupons are due. Consider the following:
Example 5: A sum of $ 1000/- is invested in 4-year
bonds with face value $100 and $10 annual coupons.
A coupon bond of this kind can be regarded as a
collection of four zero-coupon bonds maturing after 1,
2, 3 and 4 years with face value $10, $10, $10 and
$110, respectively. If the initial yield is y(0) and bonds
are traded at $91.78, then y(0) satisfies equation:
91.78 = 10e−y(0) + 10e−2y(0) + 10e−3y(0) + 110e−4y(0) .
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 An investment in coupon bonds - illustrations
(the time step in this case is 1 year).
The equation can be solved numerically to find the
yield y(0) = 12%. Number of bonds purchase at t = 0,
will be 1000/91.78 = 10.896 bonds.
After 1 year we cash the coupons, collecting $108.96,
and sell the bonds which are now 3-year coupon
bonds. (i) if y(1) = 12 %, then value of 3-year bond =
10e−0.12+ 10e−2x0.12+ 110e−3x0.12 = $93.48
So we get 108.96 + 1,018.52 ∼= 1,127.48 $ in total.
(ii) The rate drops to 10%. As a result, the coupon
bonds will be worth 10e−0.1 + 10e−2×0.1 + 110e−3×0.1 ∼=
98.73 $ each. We shall end up with $1,184.72
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 An investment in coupon bonds -illustrations
(iii) The rate goes up to 14%, the coupon bonds trading
at $88.53. The final value will be $1,073.51.
Example 6: Find the rate y(1) such that the logarithmic
return on the investment in Example 5 will be a) 12%, b)
10%, c) 14%.
(a) In order to get 12 % logarithmic return, we must earn
Amount = 1000 x e0.12 = 1127.49 $
Hence, 1127.49 -108.96 = 1018.54. Therefore, the value
of 1 bond = 1018.54 / 10.896 = 93.48
So y(1) can be obtained by solving equation:
10e−y(1) +10e−2y(1) +110e−3y(1) = 93.48. Hence y(1) = 12%.
Cases (b) and (c ) can be resolved simillarly.
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 An investment in coupon bonds -illustrations
Example 7: Consider the data as in Example 5, taking ,
(a) y(0) = y(1) = y(2) = y(3) = 12%. However, we wish to
terminate the investment after 3 years. Compute the
value of our investment after 3 years.

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 An investment in coupon bonds -illustrations
Note: 1,000 x e3×0.12 = 1433.33, hence the value of
investment is same as $1000/- is invested at risk free
rate r = 12 % for 3 years.
(b)

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 Duration
The duration of a coupon bond is a weighted average of
future payment times, where the weights are present
value of the payment at that time to the present value of
the bond.
Consider a coupon bond with coupons C 1, C2,...,CN
payable at times 0 < τn1 < τn2 < ... < τnN and face value F,
maturing at time τnN . Its current price is given by:
P(y) = C1e−τn1y + C2e−τn2y + ··· + (CN + F)e−τnN y, where we
denote the current yield y(0) by y.
Then duration D(y) is defined by
−τn1y −τn2y −τnN y
D(y) = (τn1C1e + τn2C2e + ··· + τnN(CN + F)e ) / P(y)
= w1 τn1 + w2 τn2 + ….. + wN τnN, where wi = Cie−τniy / P(y),
for i = 1, 2, …, N.
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 Duration

The duration of any future cash flow can be defined

in a similar manner.
Duration measures the sensitivity of the bond price to
changes in the interest rate. To see this we compute
the derivative of the bond price with respect to y,
−τn1y −τn2y −τnN y
P’(y) =-(τn1C1e +τn2C2e +···+τnN(CN + F)e )
which gives P’(y) = −D(y)P(y).
The last formula is sometimes taken as the definition
of duration.
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 Duration- Another meaning
Consider a 4-year bond A with annual coupons C = 10
and face value F = 100. If the yield y = 0.14, Then
P(y) = 10xe-.14+ 10xe-.28 + 10xe-.42 + 110xe-.56 = 85.65
D(y) = (10xe-.14+ 20xe-.28 + 30xe-.42 + 440xe-.56) / P(y)
= 294.84/85.65 = 3.44
If we invest P(y) amount for D(y) period we get amount =
A = P(y) x e yD(y) = 85.65 x e 0.14x3.44 = 138.64.
Bond value at the maturity i. e. after 4 years:
V(T) = 10xe3x.14+ 10xe2x.14 + 10xe.14 + 110 =149.91
Hence the value of the bond at the end of the duration is
V(d) = V(T) e y(T - D(y)) = 149.91 x e-0.14x0.56 = 138.61 ~= A.

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 Duration - illustrations
Example 8: (a) Find duration for a 6-year bond with
$10 annual coupons, $100 face value and yield of 6%.
P(y) = 10e-0.06+ 10e-0.12 + 10e-0.18 + 10e-0.24 + 10e-0.30 +
110e-0.36 = 9.42 + 8.87 + 8.35 + 7.87 + 7.41 + 76.74
= 118.66
D(y) = (9.42 + 2 x 8.87 + 3 x 8.35 + 4 x 7.87 + 5 x 7.41
+ 6 x 76.74) / 118.66 = 581.18 / 118.66
= 4.898
(b) A 6-year bond with the same coupons and yield,
but with $500 face value, will have a duration of 5.671
years. The duration of any

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 Duration - illustrations
Example 9: (a) What should be the face value F of a
5-year bond with 10% yield, paying $10 annual
coupons to have duration 4?
(b) Find the range of durations that can be obtained
by altering the face value, as long as a coupon
cannot exceed the face value.
(c) If the face value is fixed, say $100, find the level of
coupons for the duration to be 4. What durations can
be manufactured in this way?
Solution: (a) Solve for F: 4(10xe-0.1 +10xe-0.2 +10 e-0.3
+10x e-0.4 +(10 + F)xe-0.5 = (10xe-0.1 +20xe-0.2 +30 e-0.3 +
40x e-0.4 + 5(10 + F)xe-0.5
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 Duration - illustrations
(10 + F)xe-0.5 = 30xe-0.1 +20xe-0.2 +10 e-0.3
F = (30xe0.4 +20xe0.3 +10 e0.2) - 10 = 73.97
(b) (10xe-0.1+20xe-0.2 +30 e-0.3 + 40x e-0.4 + 5(10 + F)xe-0.5
D = ---------------------------------------------------------------------------------------------------------
(10xe-0.1 +10xe-0.2 +10 e-0.3 + 10x e-0.4 + (10 + F)xe-0.5
For F =10
(9.05+16.38+22.2+26.8+60.7) 135.13
D = ------------------------------------------------------------- = ---------- = 3.11
(9.05 +8.19 +7.4+ 6.7+ 12.14) 43.48
D 5 as F ∞. Range of Duration [3.11, 5)
(c) 4 = (10.478 C + 303.5) / (3.741 C + 60.7)
4.486 C = 60.7.
So, C = 13.53

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 Portfolios of Bonds
Example 10: Consider a portfolio consisting of:
(i) A 4-year bond A with annual coupons C = 10 and
face value F = 100.
(ii) A zero-coupon bond B with F = 100 and N = 1.
Find the duration of each of the bonds and of the
combined portfolio if the initial interest rate is 14%.
Solution: Verify Duration of A, DA = 3.44 years and
that of bond B, DB = 1.
Combined Portfolio can be regarded as a single bond
with coupons C1 = 110, C2 = C3 = C4 = 10, F = 100.
Verify its duration is 2.21 years.
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 The duration of a portfolio
Consider a Portfolio (aA+bB) consisting of a bonds of
type A and b bonds B and let initial yield be y.
Denote by PA(y) and PB(y) and by DA(y) and DB(y).
the values and durations of the two bonds A and B.
Then Value of aA+bB, PaA+bB = aPA(y) + bPB(y).
For finding duration of aA+bB:
1. Find duration of aA: Cleary, PaA(y) = aPA(y) and
since, - DaA(y) PaA(y) = (PaA(y))’ = (aPA(y))’ = a(PA(y))’
= - DA(y)(aPA(y)) = - DA(y)(PaA(y))
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 The duration of a portfolio
2. Find duration of A+B:
Note that PA+B = PA(y) + PB(y). And
-DA+B(y)PA+B(y)= (PA+B(y))’ = (PA(y) + PB(y))’
= (PA(y))’ + (PB(y))’ = -DA(y)PA(y) - DB(y)PB(y).
Hence, PA ( y ) PB ( y )
D A  B (y)  DA ( y)  DB ( y)
PA ( y )  PB ( y ) PA ( y )  PB ( y )

3. Therefore, D aA bB (y)  wA D A ( y )  wB D B ( y ), where

aPA ( y ) bPB ( y )
wA  and w B 
aPA ( y )  bPB ( y ) aPA ( y )  bPB ( y )
Note that wA  wB  1.
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 The duration of a portfolio - illustration
Example 11: Let durations of bonds A and B be given
as DA = 1 and DB = 3. We wish to invest $1,000 for 6
months in bonds A and B. Find a Portfolio having
duration that match the lifetime of the investment.
Solution: Suppose Portfolio consists of a bonds of
type A and b bonds of type b. We want that
0.5 = DaA+bB(y) = wA x 1 + (1-wA) x 3. This gives
wA = 1.25 and hence we invest $1250 in bonds A and
issue bonds B worth $250. If PA = 0.92 and PB = 1.01,
then we have 1250/0.92 = 1358.7 bonds of type A
and issue 250/1.01 =247.52 bonds of type B.

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 The duration of a portfolio - illustration
Example 12: Find the number of bonds of type A and
B to be bought if DA = 2, DB = 3.4, PA = 0.98, PB =
1.02 and you need a portfolio worth $5,000 with
duration 6.

Solution: 6 = DaA+bB(y) = wA x 2 + (1- wA) x 3.4 This

gives wA = -1.8571 and wB = 2.8571. We invest

14285.5 in bond B by purchsing 14285.5/1.02 =
14005.4 bonds of type B and issue 9285.5 /0.98 =
9475 bond of type [email protected]
 The duration of a portfolio - illustration
Example 13: Invest $1,000 in a portfolio of bonds with
duration 2 using 1-year zero coupon bonds with $100 face
value and 4-year bonds with $15 annual coupons and $100
face value that trade at $102.
Solution: Find the yield on the coupon bond A, by solving
equation: 102 = 15e-y+15e-2y+15e-3y +115 e-4y
This gives y = 13.37%. so the price of the zero coupon
bond PB = 100xe-0.1337 = $87.48.; DB = 1
Duration of the coupon bond:
DA=(15xe-0.1337+30xe-0.2674+45xe-0.4011+460e-0.5348)/102 = 3.29 To
find the weights wA solve: 2 = wA 3.29 + (1- wA) 1.
So wA = 0.4366 and wB ∼= 0.5634. This means that we
invest $436.59 to buy 4.2802 bonds A and $563.41 to buy
6.4403 bonds B.
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 A Dynamic Hedging
Even if a portfolio is selected with duration matching
the desired investment lifetime, this will only be valid at
the initial instant, since duration changes with time as
well as with the interest rate.
Result 1:Let D(t) be the duration of a coupon bond after
time t. If the interest rate does not change, and t is the
time before the first coupon is paid then D(t) = D(0) – t.
yt
Proof: At time t (the bond price grows by a factor of e ),
−y(τn1−t) −y(τnN −t) yt
D(t) = ((τn1−t)C1e +···+(τnN − t)(CN + F)e ) / e P(y) =
−yτn1 −yτnN
((τn1 − t)C1e +···+ (τnN − t)(CN + F)e ) / P(y) = D(0)
– t, since C1e −yτn1 + C2e −yτn2 +··+ (CN + F)e−yτnN = P(y).
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 A Dynamic Hedging
For example, Take a 5-year bond with $10 annual
coupons and $100 face value. If y = 10%, then the
duration will be about 4.16 years. Before the first
coupon is paid the duration decreases in line with
time: After 6 months it will be 4.16 – 0.5 = 3.66, and
after 9 months 4.16 − 0.75 = 3.31.
If the duration matches our investment’s lifetime
and the interest rates do not change, no action will
be necessary until a coupon becomes payable. As
soon as the first coupon is paid after one year, the
bond will become a 4-year one with duration 3.48,
no longer consistent with the investment lifetime.
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 A Dynamic Hedging

Example 14: Show that in the above illustration the

bonds will have duration 4.23 if y = 6% and 4.08 if y
= 14%.
Result 2: The duration of a 2-year bond with annual
coupons decreases as the yield increases.
Proof: Denote the annual payments by C1, C2 and
the face value by F, so that
P(y) = C1e −y + (C2 + F)e−2y,
D(y) = (C1e−y + 2(C2 + F)e−2y )/P(y) .
D’(y) = −C1(C2 + F)e−3y /P(y)2 < 0.
Hence, D(y) decreases as y increases.
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An investment strategy immune to interest rate changes

Example 15: Set the lifetime of the investment to be 3

years and the target value to be $100,000. Suppose
that the interest rate is 12% initially. If the interest rate
remained constant, we invest
100000 x e- 0.36 = $69,767.63.
We restrict our attention to two instruments, a 5-year
bond A with $10 annual coupons and $100 face
value, and a 1-year zero-coupon bond B with the
same face value. We assume that a new bond of
type B is always available. In subsequent years we
can combine it with bond A. Note that at time t = 0,
PA = $90.27, DA = 4.12 & PB = $88.69 & DB = 1.
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 Example 15 continued
This gives weights wA ∼= 0.6405, wB ∼= 0.3595
which give a portfolio with duration 3. We split the
initial sum according to the weights, spending
$44,687.93 to buy a ∼= 495.05 bonds A and
$25, 079.70 to buy b ∼= 282.77 bonds B.
Consider the following scenarios of future interest
rate changes: After one year the rate = 14%:
The value of our portfolio is the sum of:
• the first coupons of bonds A: $4,950.51,
• the face value of cashed bonds B: $28,277.29,
• the market value of bonds A held, which are now 4-
year bonds selling at $85.65: $42,403.53.
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 Example 15 continued
This gives $75,631.32 altogether.
DA(1) is now 3.44. The desired duration D = 2.
So, wA ∼= 0.4094 and wB ∼= 0.5906.
The portfolio at t = 1: 361.53 bonds A and 513.76
bonds B. (This means that we have to sell 133.52
bonds A and buy 230.9 new bonds B.)
(a) After two years the rate drops to 9%. At t = 2 is:
• the coupons of A: $3,615.30,
• the face values of B: $51,376.39,
• PA = $101.46. thus the market value of A, is:
$36,682.22. The total wealth is: $91,673.92.
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 Example 15 continued
We invest all the money in bonds B, since the
required duration is now 1. We can afford to buy
1,003.07 bonds B selling at $91.39. The terminal
value of the investment will be about $100,307.
(b) After two years the rate goes up to 16%. At t = 2
• the coupons of A: $3,615.30,
• the face values of B: $51,376.39,
• PA = $83.85. thus the market value of A, is:
$30,314.29. The total wealth is: $85,305.98.
However, the zero-coupon bonds are now cheap as
well, selling at $85.21, and we can afford to buy
1,001.07 of them, ending up with $100,107.
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An investment strategy immune to interest rate changes

Example 16: Design an investment of $20,000 in a

portfolio of duration 2 years consisting of two kinds of
coupon bonds maturing after 2 years, with annual
coupons, bond A with $20 coupons and $100 face
value, and bond B with $5 coupons and $500 face
value, given that the initial rate is 8%. How much will
this investment be worth after 2 years?
Solution: Verify that the prices and durations of the
bonds: PA(y) ∼= 120.72, PB(y) ∼= 434.95,
DA(y) ∼= 1.8471, DB(y) ∼= 1.9894.
The weights wA ∼= −7.46%, wB ∼= 107.46% give
duration 2.
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 Example 16 continued
which means that we have to invest:
In bond B $ 21492 by buying 49.41 bonds B.
And earn $ 1492 by issuing 12.36 bonds A. 10832
After one year we shall receive $247.05 from the
coupons of B and will have to pay almost the same
amount for the coupons of A.
Our final amount will be $23,470.05/-, which is almost
equal to the future value of $20,000 at 8%,
independently of any rate changes.

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 General Term Structure
Consider a model of bond prices without the
condition that the yield should be independent of
maturity.
The prices B(n, N) of zero-coupon unit bonds with
various maturities determine a family of yields y(n, N)
by B(n, N) = e−(N−n)τ y(n, N) .
Note that the yields have to be positive, since B(n, N)
has to be less than 1 for n < N.
The function y(n, N) of two variables n < N is called
the term structure of interest rates. The yields y(0, N)
dictated by the current prices are called the spot
rates.
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 General Term Structure
The initial term structure y(0, N) is a function of one
variable N. Typically, it is an increasing function, but
other graphs have also been observed in financial
markets.
In particular, the initial term structure may be flat, If
the yields may be independent of N, which is the
case considered earlier.
Example 17: If B(0, 6) = 0.96 dollars, find B(0, 3) and
B(0, 9) such that the initial term structure is flat. (τ = 1/12)
Compute y = -2 x ln (0.96) = 0.0816
Then B(0, 3) = e-0.816/4 = 0.9798.
And B(0, 9) = e-0.816 x 0.75 = 0.9406

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 The price of a coupon bond in new Model
Consider a coupon bond with coupons C1, C2,...,CN
payable at times 0 < τn1 < τn2 < ... < τnN and face value
F, maturing at time τnN . Its current price is given by:
−τn1y(0, n1) −τn2y(0, n2) −τnN y(0, nN)
P(y)=C1e +C2e +···+(CN + F)e -(*)

Note: For a coupon bond we cannot use a single rate

for discounting future payments.
Yield to maturity: The yield to maturity, and is defined to
be the number y solving the equation:
P(y) = C1e−τn1y+C2e−τn2y +···+(CN + F)e−τnN y.
Yield to maturity provides a convenient simple
description of coupon bonds and is quoted in the
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 Determine the initial term structure

To determine the initial term structure we need the

prices of zero-coupon bonds. However, for longer
maturities (typically over one year) only coupon
bonds may be traded.
Hence, it is necessary to decompose coupon bonds
into zero-coupon bonds with various maturities. This
can be done by solving the equation (*) repeatedly to
find the yield with the longest maturity, given the bond
price and all the yields with shorter maturities.

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 STRIPS program

In 1985, the U.S. Treasury, introduced a program

called STRIPS (Separate Trading of Registered
Interest and Principal Securities), allowing an
investor to keep the required cash payments (for
certain bonds) by selling the rest (the ‘stripped’
bond) back to the Treasury.
The value of the stripped bond can be found by
following the procedure described for determining
the the initial term structure.

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 Determining the initial term structure - illustration
Example 17: Suppose that a one-year zero-coupon
bond with face value $100 is trading at $91.80 and a
two-year bond with $10 annual coupons and face value
$100 is trading at $103.95. Find the initial term structure
and the value of the ‘stripped’ two-year bond.
Solution: This gives the following equations for the
yields:(1) 91.80 =100e−y(0,1), This gives: y(0, 1) ∼= 8.56%.
(2) 103.95 = 10e−y(0,1) + 110e−2y(0,2).
On substituting the value of y(0, 1) into the second
equation, we find y(0, 2) ∼= 7.45%.
As a result, the price of the ‘stripped’ two-year bond, a
zero-coupon bond maturing in two years with face value
$100, will be 100e−2y(0,2) ∼= 86.16 dollars.
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 Implications of deterministic term structure
Proposition 2: If the term structure is deterministic
(known in advance), then the No-Arbitrage Principle
implies that B(0, N) = B(0, n)B(n, N).
Proof: Case 1: Let B(0, N) < B(0, n)B(n, N):
At time 0: (i)Buy a bond maturing at time N.
(ii) Write a fraction B(n, N) of a bond maturing at n.
(Here B(n, N) is known as y(n, N) is known in
advance.) This gives B(0, n)B(n, N) − B(0, N) dollars
now.
At time n: (i) settle the written bonds, raising the
required sum of B(n, N) by issuing a single unit bond
maturing at N.
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 Proof of Proposition 2 – continued
At time N: close the position, retaining the initial profit.
Case 2: The reverse inequality B(0, N) > B(0, n)B(n,
N) can be dealt with in a similar manner, by adopting
the opposite strategy.
Employing the representation of bond prices in terms
of yields. We have: B(0, N)  ny(0,n) -  Ny(0, N)
B(n, N)  e
B(0, n)
This would mean that all bonds prices (and so the
whole term structure) are determined by the initial
term structure. However, it is clear that one cannot
expect this to hold in real bond markets.
Note: The proposition indicates that the term structure
cannot be deterministic.
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 How to secure the future interest rates?
Example 18: Suppose that the business plan of a
company will require taking a loan of $100,000 one
year from now in order to purchase new equipment.
The management expects to have the means to
repay the loan after another year and would like to
arrange the loan today at a fixed interest rate, rather
than to gamble on future rates. What rate a Financial
intermediaries can offer if the spot rates are y(0, 1) =
8% and y(0, 2) = 9% (with τ = 1)?
Solution: The Financial intermediaries (FI) can
arrange for the loan as follows:
(i) Buy 1,000 one-year bonds with $100 face value,
paying 100,000 x e−0.08∼= 92, 311.63 dollars.
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 How to secure the future interest rates?
(ii) Borrow $ 92311.63 for 2 years at 9%.
After one year the FI will receive $ 100,000 by en-
cashing the bonds which can be offered to the
company.
(iii) FI will be required to settle the loan with interest
after 2 years, the total amount to pay being
92,311.63e2×0.09 ∼= 110, 517.09 $. Thus, FI can offer
the constructed future loan with the interest rate :
ln(110,517.09/100,000) ∼= 10% or little more as
their cost for the services they provide.
Thus FI may simplify Company’s task by offering a
so-called Forward Rate Agreement.
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 The initial forward rate
• In general, the initial forward rate f(0,M,N) is an
interest rate such that B(0, N) = B(0, M)e−(N−M)τ f(0,M,N),
• 0 M N
• So f(0,M,N) = − (ln B(0, N) − ln B(0, M)) / τ (N − M).
• Note that this rate is deterministic, since it is
worked out using the present bond prices.
• It can be conveniently expressed in terms of the
initial term structure. Insert into the above expression
the bond prices as determined by the yields,
• B(0, N) = e−τNy(0,N) and B(0, M) = e−τMy(0,M), to get
• f(0, M, N) = (Ny(0, N) − My(0, M)) / (N − M).
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 The initial forward rate - illustration
Example 19: Suppose that the following spot rates are
provided by central London banks (LIBOR, the London
Interbank Offer Rate, is the rate at which money can be
deposited; LIBID, the London Interbank Bid Rate, is the
rate at which money can be borrowed):
Maturity 1 Month 2 Months 3 Months 6 Months
LIBOR 8.41% 8.44% 9.01% 9.35%
LIBID 8.59% 8.64% 9.23% 9.54%

(a) As a bank manager acting for a customer who

wishes to arrange a loan of $100,000 in a month’s time
for a period of 5 months what rate could you offer and
how would you construct the loan?
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 The initial forward rate - illustration
(b) Suppose that another institution offers the possibility
of making a deposit for 4 months, starting 2 months from
now, at a rate of 10.23%. Does this present an arbitrage
opportunity? (continuous compounding).
Solution (a): Take a loan of $ 100000 x e-0.0841/12 = 99301.62
for 6 months @9.54%. Investing it for 1 month @ 8.41%,we
get $100000/- after 1 month. Give it to the customer on loan
for 5 months. We need to repay after 6 months $99301.62 x
e0.0954/2 = I,04,153.1$.
Hence, Rate f(0, 1, 6) is given by solving:
104153.1 = 100000 ef(0, 1, 6) x 5/12. Hence,
f(0, 1, 6) = 2.4 x ln (1.041531)=0.09766 = 9.77%
(b) f(0, 2, 6) = (6 x 0.0954 – 2 x 0.0844) / 4 = 10.09 %.
So, the new offer provides an arbitrage opportunity.
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 The instantaneous forward rates
The forward rate over the interval [M, N] determined
at time n < M < N is defined by
B(n, N) = B(n, M)e−(N−M)τ f(n,M,N) , that is,
f(n, M, N) = − (ln B(n, N) − ln B(n, M)) / (N − M)τ .
The instantaneous forward rates f(n, N) = f(n, N, N + 1)
are the forward rates over a one-step interval.
Typically, when τ is one day, the instantaneous
forward rates correspond to overnight deposits or
loans. The formula for the instantaneous forward rate
f(n, N) = − (ln B(n, N + 1) − ln B(n, N)) / τ
will enable us to reconstruct the bond prices, given
the forward rates at a particular time n.
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 The instantaneous forward rates - illustration
Example 20: Let τ = 1/12 and bond prices be:
B(0, 1) = 0.9901, B(0, 2) = 0.9828, B(0, 3) = 0.9726.
Then find y(0, i) and f(0, i-1), for i = 1, 2, 3.
Solution: Since y(0, i)= - (1/(iτ)) ln(B(0, i)),
y(0, 1) = 12 ln (0.9901) = 11.94%,
y(0, 2) = 6 ln (0.9828) = 10.41%; and
Y(0, 3) = 4 ln (0.9726) = 11.11%.
f(0, i-1)=-(ln B(0, i) – ln B(0, i-1))/τ =(ln(B(0, i-1) / B(0, i))/ τ.
So, f(0, 0) = 12 x ln (1/0.9901) = 11.94%;
f(0, 1) = 12 x ln (0.9901/0.9828) = 8.88%; and
f(0, 2) = 12 x ln (0.9828 / 0.9726) = 12.52%;

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 Bond prices in terms of forward rates
Proposition 3: The bond price is given by
B(n, N) = exp{−τ (f(n, n) + f(n, n + 1) + ··· + f(n, N − 1))}.
Proof: Note that f(n, n) = −ln B(n, n + 1)/τ , since
B(n, n) = 1, so B(n, n + 1) = exp{−τf(n, n)}.
Next, f(n, n + 1) = − (ln B(n, n + 2) − ln B(n, n + 1))/ τ
and, after inserting the expression for B(n, n + 1),
B(n, n + 2) = exp{−τ (f(n, n) + f(n, n + 1))}.
Repeating this a number of times, we arrive at the
required general formula.

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 The forward rates in terms of the yields
We have a simple representation of the forward rates in
terms of the yields:
• f(n, N) = (N + 1 − n)y(n, N + 1) − (N − n)y(n, N).
• This indicates that f(n, N) can be negative if
(N + 1 − n)y(n, N + 1) < (N − n)y(n, N). For example:
If n = 0, N = 8, y(0, 8) = 9% and y(0, 9) = 7.9, then
f(0, 8) = 9 x 0.079 – 8 x 0.09 < 0.
• In particular, f(n, n) = y(n, n + 1), resulting in the
intuitive formula
y(n, N) = (f(n, n) + f(n, n + 1) +···+ f(n, N − 1))/(N − n).
• If term structure is flat, (i. e. Y(n, N) is independent of
N. then f(n, N) = y(n, N)
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 The forward rates in terms of the yields

Result: Prove that if f(n, N) increases with N, then the

same is true for y(n, N).
Proof: From the last formula for y(n, N).

(N – n)f(n, N) – f(n, n) -  - f(n, N - 1)

Y(n, N  1) – y(n, N) 
(N  1 - n)(N - n)
(f(n, N) – f (n, n))    (f(n, N) – f (n, N - 1))
  0, since
(N  1 - n)(N - n)
f(n, N) increases with N and 0  n  N.

Hence, y(n, N) also increases with N.

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 The forward rates and yields - illustration
Example 21:Now consider an example of f(n, N)
increasing with N for a fixed n, and compute the
corresponding yields f(0, 0) = 8.01%, f(0, 1) = 8.03%,
f(0, 2) = 8.08%:
y(0, 1) = f(0, 0) = 8.01%,
y(0, 2) = (f(0, 0) + f(0, 1)) /2 = 8.02%,
y(0, 3) = (f(0, 0) + f(0, 1) + f(0, 2))/3 = 8.04%.
See that f(0, n) increases then y(0, n) also increases.
However, the converse may not be true. See for
example, f(0, 0) =9.2%, f(0, 1) = 9.8%; f(0, 3) = 9.56%;
gives y(0, 1) = 9.2%, y(0, 2) = 9.5%; y(0, 3) = 9.52%.
y(0, n) increases but f(0, n) does not increase.
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 Short rates

The short rate is defined by r(n) = f(n, n). An

alternative expression is r(n) = y(n, n + 1), so this is a
rate valid for one step starting at time n. The short
rates are unknown in advance, except for the current
one, r(0). It is important to distinguish between r(n)
and f(0, n). Both rates apply to a single step from
time n to n + 1, but the former is random, whereas
the latter is known at the present moment and
determined by the initial term structure.

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 Money Market Account
The money market account denoted by {A(n), n ≥ 1},
is defined by A(n) = exp{τ (r(0) + r(1) + ··· + r(n − 1))}
with A(0) = 1, and represents the value at time n of
one dollar invested in an account attracting interest
given by the short rate under continuous
compounding. For example, if τ = 1/365 , then the
interest is given by the overnight rate. Here A(n) is
random and, as will be seen below, in general
different from exp{τny(0, n)}, the latter being
deterministic and constructed by using zero coupon
bonds maturing at time n.
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 Money Market Account - illustration
Example 22: Let τ = 1/12 , n = 0, N = 0, 1, 2, 3, and
suppose that the bond prices are as follows:
B(0, 1) = 0.9901,
B(0, 2) = 0.9828, B(1, 2) = 0.9947,
B(0, 3) = 0.9726, B(1, 3) = 0.9848, B(2, 3) = 0.9905.
Then using y(n, N) = ln (B(n, N))/ τ, we get
y(0, 1) ∼= 11.94%, y(0, 2) ∼= 10.41%,
y(0, 3)∼= 11.11%, y(1, 2) ∼= 6.38%,
y(1, 3)∼= 9.19%, y(2, 3)∼= 11.45%.
Using f(n, N) = (N + 1 − n)y(n, N + 1) − (N − n)y(n, N),
We get
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 Money Market Account - illustration
f(0, 0) ∼= 11.94%, f(0, 1) ∼= 8.88%,
f(0, 2) ∼= 12.52%, f(1, 1) ∼= 6.38%,
f(1, 2) ∼= 12.00%, f(2, 2) ∼= 11.45%.
Using r(n) = f(n, n) = y(n, n+1), we get
r(0) = f(0, 0) ∼= 11.94%, r(1) = f(1, 1) ∼= 6.38%,
r(2) = f(2, 2) ∼= 11.45%,
Using A(n) = exp{τ (r(0) + r(1) + ··· + r(n − 1))}, we
get A(0) = 1, A(1) ∼= 1.0100, A(2) ∼= 1.0154,
A(3) ∼= 1.0251.
Note: The values of B(0, 2), B(0, 3), B(1, 3) have no
effect on the values of the money market account.

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 Money Market Account - illustration
Example 23: Using the data in Example 22, compare
the logarithmic return on an investment in the
following securities over the period from 0 to 3: (a)
zero-coupon bonds maturing at time 3; (b) single-
period zero-coupon bonds; (c) the money market
account.
Solution: (a) For an investment of $100 in zero-
coupon bonds, divide the initial cash by the price of
the bond B(0, 3) = 0.9726 to get the number of
bonds held, 102.82, which gives final wealth of
$102.82. The logarithmic return = ln (102.82/100) =
2.78%.
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 Money Market Account - illustration
(b) For an investment of $100 in single-period zero-
coupon bonds, compute the number of bonds
maturing at time 1 as 100/B(0, 1) ∼= 100.99. Then,
at time 1 find the number of bonds maturing at time 2
in a similar way, 100.99/B(1, 2) ∼= 101.54. Finally,
we arrive at 101.54/B(2, 3) ∼= 102.51 bonds, each
giving a dollar at time 3. The logarithmic return is
2.48%.
(c) An investment of $100 in the money market
account, for which we receive 100A(3) ∼= 102.51 at
time 3, produces the same logarithmic return of
2.48% as in (b).
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Thank You

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