Analysis of Deterministic Cash Flows and the Term Structure of Interest Rates Readings: 1. Hull, Sections 4.1-4.

5 in Chapter 4 + Section 6.1 in Chapter 6. 2. If you need to refresh present value/time value of money/interest concepts, please review Brealey, Myers and Marcus, Fundamentals of Corporate Finance (this material is covered in IEMS 326 and assumed as prerequisites). Cash Flows Financial transactions and investment opportunities are described by cash flows they generate. Cash flow: payment made or received. Multiple cash flows are called cash flow streams. Time Value of Money A dollar today is worth more than a dollar tomorrow. A dollar today can be invested to start earning interest immediately. Valuation Problem: Find present value of all future cash flows related to a financial transaction or investment opportunity. Two types of valuation problems: Deterministic valuation problems (the timing and the amount of all cash flows are known with certainty on the valuation date) Stochastic valuation problems (the timing and/or the amount of future cash flows are not known with certainty at the valuation date) Here we briefly review valuation of deterministic cash flows (this material has been covered in IEMS 326 and assumed as prerequisite). We will work with stochastic cash flows for the rest of the quarter. Example: A Single Cash Flow in One Year Given: C1: deterministic cash flow at the end of one year (known for sure) r: interest rate for one year. Present value:

PV

C1 , 1 r

where

1 1 r

is a discount factor.

Compound Interest Compound interest: each interest payment is reinvested to earn more interest in subsequent periods. Compound interest with annual compounding: start with the amount of money A. After n years you will have (1 r)n A : A (1+ r) A (1+ r)2 A (1+ r)n A Present Value Calculations with Annual Compounding Frequency Present value of a certain cash flow one year from now:

PV

C1 . 1 r

Present value of a certain cash flow two years from now:

PV C2 . (1 r ) 2

Present value of a certain cash flow n years from now:

PV Cn . (1 r ) n

The Additivity Property of Present Values Present values are expressed in current dollars, so they are additive. Valuing a stream of future cash flows occurring at different times in the future discounted cash flow (DCF) formula:
N

PV
n

Cn n 1 (1 r )

where Cn - cash flow at the end of year n. Two deterministic cash-flow streams are called equivalent if their present values are equal.

Valuation by Discounted Cash Flow (DCF) Calculations Perpetuities No expiration or maturity date - continues to pay out interest to infinity. Suppose a perpetuity pays a dollar amount (coupon) C at the end of each year starting from year one to infinity. Assuming the discount rate is r, the present value is:

PV
n

C n 1 (1 r )

xC
n 0

xn

xC 1 x

C , r

where x Annuities

1 1 r

. This is a geometric power series.

An annuity pays a fixed amount C each year for a specified number of years. The payments stop at the end of Nth year. PV(Annuity) = PV(perpetuity paying C at the end of each year starting in year #1) minus PV(perpetuity paying C at the end of each year starting in year #N + 1), i.e.,
PV C r C r ( r 1)
N

C 1 1 . r (1 r ) N

Annuity factor = PV at discount rate r of an annuity paying $1 at the end of each year for N years. Compounding Intervals, Compounding Frequency, and Continuous Compounding Reading: Hull, Section 4.2 (very important) Previously we considered annual compounding. Any compounding interval can be considered. Example: A 10% interest rate compounded semiannually implies two six-month 5% interest periods per year. A $100 investment will be worth $105 after six months and $110.25 after one year (the $105 earns 5%). This produces higher return than the 10% interest rate with annual compounding (the $100 investment invested for one year at 10% per annum with annual compounding will be worth $110 at the end of one year). Generally, an investment of $A at the rate of r% per year compounded m times per year by the end of nth year amounts to:
r 1 m m
mn

A.

Example: valuing a coupon-bearing bond with coupons paid m times per year (a whole number of coupons remaining until maturity) PV(Bond) = PV(coupon stream) + PV(principal), i.e.,

PV (Bond)

cF m

1 1 r/m
k

F 1 r/m
N

k 1

where c: annual coupon rate (e.g., 6% per year or 0.06) F: face value of the bond (e.g., $1,000) m: coupon payment and compounding frequency (e.g., semiannual coupon, i.e., coupons are paid twice a year and m = 2) N: number of whole coupon periods between today and maturity (N/m number of years remaining to maturity) Continuous Compounding Continuous compounding is obtained in the limit when the compounding interval becomes infinitesimally small and compounding frequency goes to infinity m :
lim m r 1 m
mn

A e nr A.

For practical purposes, continuous compounding often approximates daily compounding. Continuous compounding is very important as it is used in derivatives pricing. 1. Compounding: future value at the end of nth year of the amount $A invested today for n years: e rn A . 2. Discounting: present value of $A to be received in n years: e
rn

A.

Relationships between continuous compounding and compounding with frequency m times per year Suppose that rc is the rate of interest with continuous compounding and rm is the equivalent rate of interest with compounding m times per annum. Then we have the relationship:
e rc A 1 rm m
m

A,
rc m

rc

r m ln 1 m , m

or

rm

m e

1 .

Example: Future value of $1,000,000.00 at the end of one year invested at 10% per annum, where the interest rate is quoted with different compounding frequencies: Annual (m=1) $1,100,000.00 Semiannual (m=2) $1,102,500.00 Quarterly (m=4) $1,103,812.89 Monthly (m=12) $1,104,713.07 Weekly (m=52) $1,105,064.79 Daily (m=365) $1,105,155.78 Continuous (m = infinity) $1,105,170.92 This example shows that whenever an interest rate is quoted to you, you should always find out what compounding frequency is used to produce the quote! More on continuous compounding At t = 0 we invest $1 in a money market account (MMA) that continuously compounds interest at the rate r. What is the value of our MMA balance at some time t > 0? Over an infinitesimal time period dt the interest earned on the MMA balance is:

dAt

, rAdt t

where At denotes the value of the MMA at t. As a function of time t, the value of the MMA balance satisfies the differential equation:

dAt dt

rAt

with initial condition (initial deposit $1 at t = 0):

A0 1 .
Unique solution to this initial value problem is:
At e rt , t
0.

Continuously compounded money market account balance accumulates according to the exponential function. The value of the money market account
{ At ert , t 0}

is also called accumulation factor.

One needs to be careful about two issues when dealing with interest rates. Two issues with interest rate quotes: 1. Compounding frequency used to quote an interest rate 2. Day count convention used Whenever an interest rate is quoted, always check what day count convention and compounding frequency are used to produce the quote. Read Hull, Section 6.1 on the day count conventions issue. Also, see the Appendix to these lecture notes. II The Term Structure of Interest Rates Above we assumed that the interest rates for all maturities are the same. In reality there is a term structure of interest rates. Here are the term structures of US Treasury rates from 2001 to the present (from Bloomberg web site http://www.bloomberg.com). Term structure on January 2001:

Term structure on December 29, 2001:

Term structure on December 27, 2002:

Term structure on December 26, 2003:

Term Structure on December 17, 2004

Term structure on Nov 23, 2005:

Term Structure on December 28, 2006

Term structure on Jan 8 2008

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Term Structure on Dec 30, 2008

Term Structure on Dec 22, 2009

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Term Structure on Dec 28 2010

Term structure on Nov 25, 2011

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Term structure on Dec 31, 2013

Zero-coupon Bonds A default-free zero-coupon bond with the face value $F maturing at time T in the future is a security that pays $F at time T (investor receives one certain cash flow $F at time T). Zero-coupon bond prices are quoted as a percent of par (face value). Prices of zero-coupon bonds maturing at different times and having face values of one dollar are basic building blocks to value other deterministic cash flows. Notation: P(t, T ) denotes the price at time t of a zero-coupon bond maturing at time T and having the face value of one dollar.

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Coupon-bearing Bonds Consider a coupon-bearing bond maturing at time T in the future, with the principal (face value) F, and coupons Ci at times ti, i=1,2,, N. Then the coupon-bearing bond can be represented as a portfolio of zero-coupon bonds (zeros). The bond price at time zero is:
N

B(0)
i 1

P(0, ti )Ci

P(0, tN ) F .

Generally, PV of any deterministic (known for sure) cash flow stream can be expressed by the formula that uses the prices of zero-coupon bonds as discount factors:
N

PV
i 1

P(0, ti )Ci ,

where: t = 0 : todays date; Ci : cash flow at time ti; P(0, ti) : discount factor for money invested today for the period [0, ti]. It is equal to todays price of a default-free zero-coupon bond maturing at time ti with face value of $1. Zero-coupon bond yields and spot rates
P(t, T ) : price at time t of a default-free zero-coupon bond that pays $1 at maturity T. Prices of zero-coupon bonds with unit face values serve as discount factors for deterministic cash flows. R(t, T ) : zero-coupon bond yield (continuously compounded default-free rate of interest for the period from t to T). The relationship between zero-coupon bond prices and yields: 1 ln P(t, T ) . P(t, T ) e R( t ,T )(T t ) , and R(t, T ) T t The yield R(t, T ) as a function of maturity T (when t is fixed) is called the zero-coupon yield curve at time t. It shows the relationship between zero-coupon rates and maturity T. Zero-coupon yields are also called spot rates: R(t, T ) is a spot interest rate on a risk-free investment made today (time t) and lasting until time T (maturity date).

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Appendix. Accrued Interest (see also Hull, Section 6.1) So far we have worked with coupon-bearing bonds assuming there are a whole number of coupons left between today (the valuation date) and maturity. What if we are purchasing a bond on some date that falls between the two coupon payment dates? Then we need to perform what is known as the accrued interest calculation. Accrued interest represents the value of interest earned (accrued) since the last coupon payment date. Given: interest earned over some reference period (e.g., time between two coupon payments). Problem: calculate interest earned over some other time period, e.g., time passed between the last coupon payment and todays date. To do this calculation you need to know which day count convention is used in quoting the interest rate. Day count convention: X/Y, where X: defines the way in which the number of days between two dates is counted; Y: defines the way in which the total number of days in the reference period is computed. Interest earned between two dates = (interest earned in the reference period) * (number of days between dates) / (number of days in the reference period). The following three types of day count conventions are used in practice: 1. Actual/actual (in period) 2. 30/360 3. Actual/360 In the U.S. fixed income markets: 1. Actual/actual is used for T-bonds (semiannual coupons) 2. 30/360 is used for corporate and municipal bonds (semiannual coupons) 3. Actual/360 is used for T-bills and money market instruments Example: calculate accrued interest on an 8% bond since the last coupon payment. Coupons: March 1 - September 1; Last coupon: March 1; Todays date: July 3. Calculate accrued interest from the last coupon on March 1: March 1 - September 1: 184 actual days

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March 1 - July 3:

180 days on the 30 day basis 124 actual days 122 = 4*30 + 2 days on the 30 day basis

Then the accrued interest is: 4*124/184 = $2.6957 on the actual/actual basis for T-bonds, or 4*122/180 = $2.7111 on the 30/360 basis for corporate bonds. US Treasury bond prices reported in the financial pages do not include the accrued interest (they are called clean prices). The price the buyer actually pays (dirty price) is the quoted (clean) price plus the accrued interest: Accrued interest = (annual coupon/2)*(number of days since the last coupon date/number of days in the coupon period). Note that annual coupon is divided by 2 because T-bonds pay interest seminally and c is the annualized coupon rate quoted with semiannual compounding. Example: Treasury Bonds and Bond Equivalent Yield (general case not necessarily whole number of coupons left to maturity) Treasury notes and bonds are traded over the counter. Financial institutions that are authorized to be U.S. government securities dealers provide bid/ask quotes. T-notes and T-bonds are quoted in units of one 32nd on a 100-dollar par basis. The yield-to-maturity on your bond investment solves the following equation:
N

B A
n 1

cF / 2 1 r/2
n 1

F 1 r/2
N 1

where B quoted (clean) asking price of the bond (without the accrued interest) A accrued interest to be added to the clean price (A + B is the dirty price to be paid by the bond buyer) c annual coupon rate F face value of the bond r yield-to-maturity to be found by solving this equation numerically N the number of coupons remaining until maturity = (Number of days until the next coupon payment)/(Number of days in the coupon period)

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