Interest Rates

Derivatives Securities (MFFINTECH 6003)

Hugh Kim

The University of Hong Kong

Treasury Rates
I Interest rates on securities issued by a government in its own
currency
USA:
I Treasury Bills: zero-coupon bonds; issued weekly; maturities of
4, 13, 26, 52 weeks
I Treasury Notes: coupon bonds (semi-annual payments);
maturities between 2 and 10 years (2, 3, 5, 7, 10 years)
I Treasury Bonds: coupon bonds (semi-annual payments);
maturities between 20 and 30 years
I Considered to be risk free (in nominal terms)
I But inflation should be considered as risk!
I Treasury Inflation-Protected Securities (TIPS): principal
adjusted to CPI; coupon bonds (semi-annual payments);
maturities of 5, 10, 30 years
London Interbank Offered Rate (LIBOR)
I Interest rate at which large banks lend money to each other
I Reference rate used for many transactions, e.g., syndicated loans,
mortgages, derivatives
I Commonly used as “risk free” rate to price derivatives

I LIBOR is set daily by Intercontinental Exchange (ICE,

https://www.theice.com/iba/libor; before 2014 LIBOR it was
administered by British Bankers Association)
I Available for major currencies and maturities up to 12 months
I LIBOR scandal in 2012 (and default of Lehman Brothers in
2008) raised questions about using LIBOR as “risk free” rate to
price derivatives; regulators intend to discontinue it by the end
of 2021:
Federal Funds Rate
I In the USA banks have to hold reserves in Federal Reserve Bank
I To meet requirements banks trade balances held at the Federal
Reserve with each other
I Federal funds effective rate is the interest rate that clears the
market
I Maturity: overnight
I Uncollateralized contracts
I Federal funds target rate is set by the Federal Open Market
Committee
I Federal Reserve Bank actively trades in the treasury market to
achieve the target rate
I "Discount rate": rate at which banks can borrow directly from
Fed
Overnight Rates
I Secured Overnight Financing Rate (SOFR, USD)
I Sterling Overnight Index Average (SONIA, GBP)
I Euro Overnight Index Average (EONIA, EUR)
I Hong Kong Overnight Index Average (HONIA, HKD)
I Longer maturities: Overnight Indexed Swap (OIS) Rates
Repurchase Agreement (Repo Rate)
I Agreement to sell a security today and buy it back in the future
for a slightly higher price
I The agreed price increase determines the Repo Rate
I Even better than collateralized loan
I Almost risk free
Compounding of Interest Rates
I The compounding frequency is the unit of measurement for
interest rates
I The effective annual interest rate depends on the compounding
frequency of the stated annual interest rate
I Compounding m-times per annum (m-times c.p.a.) at rate r
yields the effective annual interest rate
 r m
1+ −1
m
I The effective interest rate over time period (T − t ) is
 r  m (T −t )
1+ −1
m
Compounding of Interest Rates
I In the continuous time limit (continuous compounding, c.c.),
the effective interest rate over time period (T − t ) is
 r  m (T −t )
lim 1+ − 1 = e r (T −t ) − 1
m→∞ m
I Suppose rc is the annual interest rate with c.c. and rm is the
annual interest rate with m-times c.p.a., then rc and rm are
equivalent iff  rm 
rc = m ln 1 +
m
or  rc 
rm = m e m − 1
Illustration for r = 10%

Compounding Frequency Effective Annual Interest Rate

Annual (m = 1) 10%
Semi-annual (m = 2) 10.250%
Quarterly (m = 4) 10.381%
Monthly (m = 12) 10.471%
Weekly (m = 52) 10.506%
Daily (m = 365) 10.516%
Continuously (m → ∞) 10.517%
Spot Rates
I The (T − t )-year spot rate rt,T is the stated annual interest
rate promised at time t for a fixed investment horizon of
(T − t ) years
I Instantaneous spot rate at time t for a horizon (T − t ) → 0 is
called short rate rt
Spot Rates
Illustration of the term structure of interest rates (yield curve) at
time t:

T −t Spot Rate rt,T (c.c.)

T →t rt = 2.50% Yield Curve
0.5 rt,t +0.5 = 4.00% 7
6
1 rt,t +1 = 5.00%

Spot Rate (in %)

5
2 rt,t +2 = 5.50% 4
3 rt,t +3 = 5.90% 3
2
4 rt,t +4 = 6.10% 1
5 rt,t +5 = 6.25% 0
0 0.5 1 2 3 4 5 10 30
10 rt,t +10 = 6.40% T-t (in years)
30 rt,t +30 = 6.50%
Bond
I A bond is a contract which promises future cash flows Ci at
time ti ∈ {t1 , t2 , ..., tN } with ti > 0
I Time tN is the maturity of the bond
I A bond with (risk free) cash flows Ci at time ti ∈ {t1 , t2 , ..., tN }
should trade for
N
P0 = ∑ e −r 0,ti ti
Ci
i =1
I A zero-coupon bond is a bond which does not pay any coupons
but some face value F at maturity
Coupon Bond
I A coupon bond pays face value F at maturity and frequently
some coupons C until maturity
I The price of a (risk free) coupon bond is equal to the discounted
cash flows using the appropriate spot rate as the discount rate
I A coupon bond with n (risk free) coupon payments per year of
size C = nc F for T -years and face value F should trade for

nT
c
∑ e −r
t
P0 = 0,(t/n) n F + e −r0,T T F
t =1 n

I When P0 = F then we say the bond trades at par

Questions
I Consider the previous term structure example
I What are the prices of the half-year, 1-year, and 3-year (risk
free) zero-coupon bonds with face value F = $1, 000?

I What is the price of a (risk free) 2% (annual) coupon bond with

a maturity of 3 years and face value F = $1, 000? What if
c = 10%?
Bond Yield
I The bond yield y is a constant discount rate that makes the
present value of the bond’s cash flows equal to the bond’s
market price
I Consider a bond with price P0 and cash flows Ci at time
ti ∈ {t1 , t2 , ..., tN }
N
I y solves the equation P0 = ∑ e −yti Ci
i =1

I The bond yield is a weighted average of the spot rates

I The yield of a (risk free) zero-coupon bond with T -years
maturity is equal to the T -year spot rate
I The yield is equal to the coupon rate for a bond which trades at
par
⇒ Floating rate bonds trade at par
Questions
I What is the yield of a (risk free) 2% (annual) coupon bond with
a maturity of 3 years, face value F = $1, 000, and current price
(T =3,c =0.02)
P0 = $891? What if c = 10% and
(T =3,c =0.1)
P0 = $1, 106?
Forward Rates
Definition
(T ,T )
The forward rate ft 1 2 at time t for period [T1 , T2 ] with
t < T1 < T2 is the future interest rate at which buyer and seller
(lender and borrower) are willing to agree at time t to trade in the
future (at time T1 ) a risk free zero-coupon bond (or an equivalent
credit contract) with maturity at time T2 (and no money is
exchanged today).

No arbitrage requires the forward rate to be:

(T1 ,T2 ) rt,T2 (T2 − t ) − rt,T1 (T1 − t )

ft =
T2 − T1
Forward Rate Agreements (FRA)
I Forward rates are traded (locked-in) through Forward Rate
Agreements (FRA)
I FRAs are used by many institutions to hedge unexpected
changes in the interest rate
I FRAs exist on all major currencies in the world
I Market for FRA is quite liquid
I As substitutes of FRAs there are also futures contracts traded
on short-term credit instruments
Example
Horizon T − t Spot Rate (c.c.) Forward rates (c.c.)
T →t rt = 2.50%
0.5 rt,t +0.5 = 4.00%
(t +0.5,t +1)
1 rt,t +1 = 5.00% ft = 6.00%
(t +1,t +2)
2 rt,t +2 = 5.50% ft = 6.00%
(t +2,t +3)
3 rt,t +3 = 5.90% ft = 6.70%
(t +3,t +4)
4 rt,t +4 = 6.10% ft = 6.70%
(t +4,t +5)
5 rt,t +5 = 6.25% ft = 6.85%
(t +5,t +10)
10 rt,t +10 = 6.40% ft = 6.55%
(t +10,t +30)
30 rt,t +30 = 6.50% ft = 6.55%
Forward Rates: Properties

(T1 ,T2 ) T1 − t
ft = rt,T2 + (rt,T2 − rt,T1 )
T2 − T1

I if rt,T1 < rt,T2 (upward sloping yield curve) then ft(T1 ,T2 ) > rt,T2
I if rt,T1 > rt,T2 (downward sloping yield curve) then
(T ,T )
ft 1 2 < rt,T2

I if rt,T1 = rt,T2 (flat yield curve) then ft(T1 ,T2 ) = rt,T2

Derivation of Forward Rates
I Strategy 1: at time t invest $1 in (T2 − t )-year zero-coupon
bond (spot rate rt,T2 ) ⇒ receive $e rt,T2 (T2 −t ) at time T2
I Strategy 2: at time t invest $1 in (T1 − t )-year zero-coupon
bond (spot rate rt,T1 ), and sign contract to invest $e rt,T1 (T1 −t )
at time T1 in zero-coupon bond with maturity at T2 and fixed
(T ,T )
future interest rate ft 1 2 (forward rate agreed at time t) ⇒
receive $e rt,T1 (T1 −t ) at time T1 from (T1 − t )-year zero-coupon
bond, but have obligation to re-invest $e rt,T1 (T1 −t ) again at
(T ,T )
interest rate ft 1 2 , $0 cash flow at time T1 ⇒ at time T2
(T1 ,T2 ) (T1 ,T2 )
receive $e rt,T1 (T1 −t ) e ft ( T2 − T1 ) = $e rt,T1 (T1 −t )+ft ( T2 − T1 )

I Both strategies are risk free ⇒ have to pay the same return!
(T1 ,T2 )
e rt,T2 (T2 −t ) = e rt,T1 (T1 −t )+ft ( T2 − T1 )
Arbitrage Opportunity
rt,T2 (T2 −t )−rt,T1 (T1 −t )
I Is there an arbitrage if ft(T1 ,T2 ) > T2 − T1 ? How
can you make money?
I At time t:
I Borrow $1 for (T2 − t ) years at rt,T2
I Lend $1 for (T1 − t ) years at rt,T1
I Sign contract to lend $e rt,T1 (T1 −t ) from time T1 to T2 at ft(T1 ,T2 )
I At time T1 :
I Receive $e rt,T1 (T1 −t ) from $1 loaned at time t for (T1 − t ) years
at rt,T1
I Lend $e rt,T1 (T1 −t ) as agreed at time t for (T2 − T1 ) years at
(T ,T )
ft 1 2
I Cash flow at time T1 : $0
I At time T2 :
I Pay back $e rt,T2 (T2 −t ) borrowed at time t for (T2 − t ) years at
rt,T2
(T ,T )
I Receive $e rt,T1 (T1 −t ) e ft 1 2 (T2 −T1 ) from $e rt,T1 (T1 −t ) loaned at
(T ,T )
time T1 for (T2 − T1 ) years at ft 1 2
I Cash flow at time T2 :
(T1 ,T2 )
$e rt,T1 (T1 −t )+ft (T2 −T1 ) − $e rt,T2 (T2 −t ) > $0
Arbitrage Opportunity
rt,T2 (T2 −t )−rt,T1 (T1 −t )
I Is there an arbitrage if ft(T1 ,T2 ) < T2 − T1 ? How
can you make money?
I At time t:
I Lend $1 for (T2 − t ) years at rt,T2
I Borrow $1 for (T1 − t ) years at rt,T1
I Sign contract to borrow $e rt,T1 (T1 −t ) from time T1 to T2 at
(T ,T )
ft 1 2
I At time T1 :
I Borrow $e rt,T1 (T1 −t ) as agreed at time t for (T2 − T1 ) years at
(T ,T )
ft 1 2
I Pay back $e rt,T1 (T1 −t ) from $1 borrowed at time t for (T1 − t )
years at rt,T1
I Cash flow at time T1 : $0
I At time T2 :
I Receive $e rt,T2 (T2 −t ) loaned at time t for (T2 − t ) years at rt,T2
(T ,T )
I Pay back $e rt,T1 (T1 −t ) e ft 1 2 (T2 −T1 ) from $e rt,T1 (T1 −t ) borrowed
(T ,T )
at time T1 for (T2 − T1 ) years at ft 1 2
I Cash flow at time T2 :
(T1 ,T2 )
$e rt,T2 (T2 −t ) − $e rt,T1 (T1 −t ) e ft (T2 −T1 ) > $0
Forward Rates: Questions
I Suppose the 1-year spot rate is 5% and it is expected to
increase to 10% in one year time
I Suppose the forward rate for the period between next year and
the year after is 7%

I Is there an arbitrage opportunity if the yield curve is increasing

and the 2-year spot rate is 6%? What do you do?

I Is there an arbitrage opportunity if the yield curve is flat? What

do you do?
Forward Rates: Final Remarks
I Forward rates are determined using “no arbitrage” argument
I Implied by the current term structure of interest rates
I Independent of expectations about future changes in the short
rate or future changes in the yield curve
Theories of Term Structures
I Expectations Theory: forward rates equal expected future spot
rates
I Market Segmentation Theory: short, medium and long rates are
traded in independent markets
I Liquidity Preference Theory: forward rates are higher than
expected future spot rates
Duration
I The duration of a bond is a measure of how long on average the
bondholder has to wait for cash flows
I Duration D of a bond with price P0 , cash flows Ci at time
ti ∈ {t1 , t2 , ..., tN }, and yield y is defined as
N
Ci e −yti
D= ∑ ti P0
i =1

I Weighted average of times of cash flows

I Duration of a bond is large (small) if the bond pays out much of
its cash flows late (early) in time
I The duration for a bond portfolio is the weighted average
duration of the individual bonds in the portfolio with weights
proportional to prices
Duration: Questions
I What is the duration of a 2% (annual) coupon bond with a
maturity of 3 years, face value F = $1, 000, current price
(T =3,c =0.02)
P0 = $891, and yield y = 5.89%? What if c = 10%,
(T =3,c =0.1)
P0 = $1, 106, and y = 5.85%?
Bond Price Volatility
I The bond volatility with respect to changes in the yield is
∂P0 (y )
defined as ∂y
P0
 
−yti C
∂P0 (y ) ∂
∑N
i =1 e i ∑N −yti C
∂y ∂y i =1 (−ti ) e i
= = = −D
P0 P0 P0
I For a small change in the yield ∆y the percentage change in the
bond price is well approximated by
∂P0 (y )
∆Po
∆y
∂y
≈
P0 P0
I To hedge the exposure of a portfolio against small unexpected
parallel shifts in the yield curve, one has to match the duration
of assets and liabilities
Bond Price Volatility: Convexity
I If changes in the yield ∆y are large, the approximation
∂P0 (y )
∆Po
P0 ≈ ∂y
P0 ∆y is not very good
I A second order Taylor expansion delivers a better approximation
∂2 P0 (y )
∂y 2
I We define a bond’s convexity as P0
 
∂2 P0 (y ) ∂2 −yti C
∑N
i =1 e i ∑N 2 −yti C
∂y 2 ∂y 2 i = 1 ti e i
= =
P0 P0 P0
I The percentage change in the bond price in response to a
change in the yield ∆y is well described by
∂P0 (y ) ∂2 P0 (y )
∆Po 1 ∂y 2
∆y + (∆y )2
∂y
≈
P0 P0 2 P0