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Interest Rates and Fixed
Income
1 What are interest rates? Time value of money: how much is worth today one dollar paid in the future? Debt is the life blood of the modern economy Governments, companies and consumers borrow money. Interest rates are a major determinant of the value of these liabilities
2 3 Interest compounding Savings institutions (banks, money market funds) pay interest income on deposits An initial deposit grows in time by interest compounding Interest is accrued periodically (daily, monthly, yearly). An interest rate must be quoted together with its accrual frequency.
4 Outline of class Types of interest rates Measuring interest rates: discrete and continuous compounding Yield curve: a snapshot of today’s interest rates. Determining the yield curve from data Bonds and their valuation and risk: duration and convexity
5 Types of Rates A wide variety of interest rates: Zero rates LIBOR, now SOFR Swap rates Treasury rates Fed funds rate Repo rates …
6 Zero Rates The zero rate (or spot rate) R(T), for maturity T is the rate of interest earned on an investment that provides a payoff only at time T
Defined in terms of the discount factor D(T) – the
value today of a dollar paid at time T - as
D(T) = exp(-R(T) T)
7 Quoting Interest Rates The compounding frequency used for an interest rate is important The difference between quarterly and annual compounding is analogous to the difference between miles and kilometers
8 Impact of Compounding When we compound m times per year at rate R an amount A grows to A(1+R/m)m in one year Compounding frequency Value of $100 in one year at 10% Annual (m=1) 110.000 Semiannual (m=2) 110.250 Quarterly (m=4) 110.381 Monthly (m=12) 110.471 Weekly (m=52) 110.506 Daily (m=365) 110.515 Continuous (m→∞) 110.517
9 Continuous Compounding (Page 82-83)
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
10 Conversion Formulas (Page 83) Define Rc : continuously compounded rate Rm: same rate with compounding m times per year
11 Examples 10% with semi-annual compounding is equivalent to 2ln(1.05)=9.758% with continuous compounding 8% with continuous compounding is equivalent to 4(e0.08/4 -1)=8.08% with quarterly compounding Rates used in option pricing are nearly always expressed with continuous compounding
12 LIBOR LIBOR used to be the benchmark for interbank borrowing rates (until June 2023). This was the rate of interest at which a AA-rated bank could borrow money on an unsecured basis from another bank LIBOR was open to manipulation, and became controversial after several manipulation attempts were uncovered. For this reason it was phased out over the past 5 years. It ceased being published in June 2023.
13 The new reference rates
US dollar: SOFR (secured overnight funding rate)
GBP: SONIA (sterling overnight index average EU: ESTR (euro short-term rate), co-exists with EURIBOR Switzerland: SARON (Swiss average overnight rate) Japan: TONAR (Tokyo average overnight rate) Repo rate Repurchase agreement is a type of short-term borrowing where a financial institution that owns securities agrees to sell them for X and buy them back in the future (usually the next day) for a slightly higher price, Y The financial institution obtains a loan. The rate of interest is calculated from the difference between X and Y and is known as the repo rate Tri-party repo
Example: hedge fund borrows cash from a
money market fund using a financial institution (dealer) as intermediary SOFR The repo market is the lifeblood of Wall Street The gross size of this market is about $5.1 trillion The SOFR rate is calculated daily by the Federal Reserve from repo rates: Secured Overnight rate (1-day) Funding rate Treasury Rate Rate on instruments issued by a government in its own currency In the US, the US Treasury issues debt instruments: Treasury Bills (1m, 3m, 6m, 1y) Treasury Notes (2Y, 5Y, 7Y) Treasury Bonds (10Y,30Y) 100Y? https://home.treasury.gov
18 Normal shape of the Treasury curve
Published daily at https://www.treasury.gov/resource-center/data-chart-center/
19 Yield Curve Properties/Assumptions
Zero rates should be positive
Yield curve should be increasing(?) Normal vs. Inverted yield curves
Bond investors expect to be paid more for long-term bonds
than for short-term bonds. Once in a while, short-term rates rise above long-term rates. This is called an inverted yield curve, and it is considered to anticipate a recession. 20 Recent Treasury yield curve
From https://www.ustreasuryyieldcurve.com/ The U.S. Fed Funds Rate Unsecured interbank overnight rate of interest Allows banks to adjust the cash (i.e., reserves) on deposit with the Federal Reserve at the end of each day The effective fed funds rate is the average rate on brokered transactions The central bank may intervene with its own transactions to raise or lower the rate Similar arrangements in other countries
22 Bonds Simplest debt instrument: issued by governments, municipalities or corporations Pays coupons (fixed or floating, linked to a reference rate) Can be non-callable or callable May be converted to shares of the issuing company (convertible bonds)
23 Bond Pricing To calculate the cash price of a bond we discount each cash flow at the appropriate zero rate [For this lecture:] Assume bond issuer will never default
24 Example (Table 4.2, page 84) Maturity (years) Zero rate (cont. comp.) 0.5 5.0 1.0 5.8 1.5 6.4 2.0 6.8
Example: the theoretical price of a two-year bond providing a 6% coupon
semiannually is
25 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 (continuously compounded) is given by solving
to get y=0.0676 or 6.76%.
26 Par Yield The par yield for a certain maturity is the coupon rate that causes the bond price to equal its face value. In our example we solve
27 Determining the yield curve The yield curve is the graphical representation of the zero rate R(T) plotted as a function of maturity The yield curve can be determined from prices of bonds with several maturities, using a method called bootstrapping
28 Example: Data to Determine Zero Curve (Table 4.3, page 86)
29 The Bootstrap Method An amount 0.4 can be earned on 99.6 during 3 months. Because 100=99.4e0.01603×0.25 the 3-month rate is 1.603% with continuous compounding Similarly the 6 month and 1 year rates are 2.010% and 2.225% with continuous compounding
30 The Bootstrap Method continued To calculate the 1.5 year rate we solve
to get R = 0.02284 or 2.284%
Similarly the two-year rate is 2.416%
31 Zero Curve Calculated from the Data (Figure 4.1, page 87)
32 Forward Rates
Definition: The forward rate is the future zero
rate implied by today’s term structure of interest rates
33 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
This formula is only approximately true when rates are
not expressed with continuous compounding
34 Application of the Formula Year (n) Zero rate for n-year Forward rate for nth investment year (% per annum) (% per annum) 1 3.0 2 4.0 5.0 3 4.6 5.8 4 5.0 6.2 5 5.5 6.5
35 Bonds: Duration and convexity The sensitivity of the bond price to changes in the yield curve is measured by duration and convexity Duration: the slope of the price vs shift of yield curve Convexity: the curvature of the price vs shift of yield curve
36 Duration (page 94-97) Duration of a bond that provides cash flow ci at time ti is
where B is its price and y is its yield
(continuously compounded)
37 Convexity The convexity, C, of a bond is defined as
This leads to a more accurate relationship
When used for bond portfolios it allows larger shifts in
the yield curve to be considered, but the shifts still have to be parallel
38 Duration and Bond Price change Duration offers a simple (approximate) formula for the change in the price of the bond for a given change in yield.
Under this approximation, bond price changes are linear in yield changes
39 Bond Portfolios The duration for a bond portfolio is the weighted average duration of the bonds in the portfolio with weights proportional to prices The key duration relationship for a bond portfolio describes the effect of small parallel shifts in the yield curve What exposures remain if duration of a portfolio of assets equals the duration of a portfolio of liabilities?
40 Forward Rate Agreement A forward rate agreement (FRA) is an OTC agreement that a certain rate will apply to a certain principal during a certain future time period - Simplest IR derivative
R(T1,T2) Receive R(T1,T2)
t=0 (today) T1 T2 Pay fixed rate K
41 Forward Rate Agreement: Key Results
An FRA is equivalent to an agreement where interest at
a predetermined rate, RK is exchanged for interest at the market rate An FRA can be valued by assuming that the forward interest rate, RF , is certain to be realized This means that the value of an FRA is the present value of the difference between the interest that would be paid at interest at rate RF and the interest that would be paid at rate RK
