Lecture 7

Fixed Income Securities (I)

Forwards and Future prices
Objectives
Look at practical aspects of bonds
Examine the yield curve and the term structure
Understand how forward and future rates are
estimated
Investigate interest rate futures
AFF5040-L07 2
Growth of Invested
Funds
Typical bond
Reinvestment
assumption
Problem: Interest rates
Change
How do they change?
AFF5040-L07 3
Quoted Yields vs.
Realized Yields
Suppose that you invested in Jan 2000 in the 10 year US
Treasury Note with 8% YTM
Are you guaranteed the yield of 8% on your investment?




The realized yield on your investment depends on:
Capital gains or losses if bond is sold prior to maturity
The yield on reinvestment of coupon payments




! YTM calculations assume that
bond is held to maturity
coupon payments are reinvested at YTM
AFF5040-L07 4
Realized Yields: Total
Returns Example
Suppose that you invested in Jan 2000 in the 10 year
8% US Treasury Note sold at par
Par bond implies that YTM = 8%
You plan to hold this bond for 3 years and reinvest
coupons at the market rate
Suppose that the next day after your purchase the
market yield falls to 6%
AFF5040-L07 5
Realized Yields: continued
Total return will now consist of







Your total annual return for the 3 year holding period will be 10.82%

at the end of year 3
Coupon payments at 8%
paid semiannually $4 * 6 = $24.00
Interest on coupon payments at 6%
paid semiannually $1.87
Capital gain on the bond
(sold after year 3 coupon) Bond price = $111.30
87 . 1 $ 24 $
2
06 . 0
1 4 $
1 2 3
0
=
|
.
|

\
|
+

= i
i
% 82 . 10
17 . 137
2
1 100
3 2
=
=
|
.
|

\
|
+

y
y
( )
( )
( )
30 . 111 $
03 . 0 1
100 $
03 . 0 1 4 $
14
2 3 10
1
=
+
+ +


=

i
i
AFF5040-L07 6
Term Structure of Interest
Rates (Yield Curve)
Is there a single interest rate?

Interest rates vary considerably depending on how
long you are going to borrow/lend:
Long term interest rates reflect
investors expectations of future real interest rates and
inflation in coming years
risk premium associated with long term
lending/borrowing arrangements
If either inflation or the real interest rate are
expected to change in the future, then long term
rates will differ from short term rates
AFF5040-L07 7
Yield Curve: U.S.
Government Bonds
A yield curve is a
chart that graphically
depicts the yields of
different maturity
bonds of the same
credit quality and type.

The yield curve is also
called the "Term
Structure of Interest
Rates."

http://www.stockcharts.com/charts/YieldCurve.html
AFF5040-L07 8
Figure 15.1 Treasury
Yield Curves
AFF5040-L07 9
Australian Government
Yield Curve

10 AFF5040-L07
As at 4
th
April 2012
http://www.bloomberg.com/markets/rates-bonds/government-bonds/australia/
Yield Curve and Interest
Rate Risk
On one hand, yield curve rates reflect todays expectations
of interest rates in the future
On the other hand, yield curve rates also reflect the risk
premium over longer maturities, since holding long-term
bonds could be risky
Short rates refers to the rates that apply at the time
Spot rates are zero coupon equivalent rates for realised cash
flows in each year
We use spot rates and forward rates to analyse interest rate
risk
! Forward rates are generally higher than expected actual
rates, reflecting the risk premium
AFF5040-L07 11
Two Types of Yield Curves
Pure Yield Curve
The pure yield curve
uses stripped or zero
coupon Treasuries.
The pure yield curve
may differ significantly
from the on-the-run
yield curve.
Calculated using
bootstrapping; see
Hull 4.5
On-the-run Yield Curve
The on-the-run yield
curve uses recently
issued coupon bonds
selling at or near par.
The financial press
typically publishes on-
the-run yield curves.
12
Bootstrapping simple
example
We have the following security yields:




Calculate the 18 month zero coupon rate


Maturity Yield
6 month (zero coupon) 4%
12 month (zero coupon) 4.5%
18 month 5% coupon, semi-
annual
5%
Coupon = YTM so
price = $1,000
( ) ( )
% 081 . 5 z so
1
025 , 1
045 . 1
25
04 . 1
25
1000
1.5
5 . 1
5 . 1
5 . 0
=
+
+ + =
z
Bond Pricing
Yields on different maturity bonds are not all
equal.
We need to consider each bond cash flow as a
stand-alone zero-coupon bond.
Bond stripping and bond reconstitution offer
opportunities for arbitrage.
The value of the bond should be the sum of the
values of its parts.


AFF5040-L07 14
Prices and Yields to Maturities on
Zero-Coupon Bonds ($1,000 @ Par)
15
Figure 15.2 Two 2-Year
Investment Programs
16
Yield Curve Under
Certainty
Buy and hold vs. rollover:



Next years 1-year rate (r
2
) is just enough to make
rolling over a series of 1-year bonds equal to
investing in the 2-year bond.

| |
2
2 1 2
1
2
2 1 2
(1 ) (1 ) (1 )
1 (1 ) (1 )
y r x r
y r x r
+ = + +
+ = + +
AFF5040-L07 17
Spot Rates vs. Short Rates
Spot rate the rate that prevails today for a given
maturity
Short rate the rate for a given maturity (e.g. one
year) at different points in time.
A spot rate is the geometric average of its
component short rates.
AFF5040-L07 18
Short Rates versus Spot
Rates
19
Short Rates and
Yield Curve Slope
When next years short
rate, r
2
, is less than this
years short rate, r
1
, the
yield curve slopes down
Called inverse yield
curve
May indicate rates are
expected to fall.

When next years short
rate, r
2
, is greater than
this years short rate,
r
1
, the yield curve
slopes up
Called normal yield
curve
May indicate rates are
expected to rise.


AFF5040-L07 20
1
1
) 1 (
) 1 (
) 1 (

+
+
= +
n
n
n
n
n
y
y
f
f
n
= one-year forward rate for period n
y
n
= yield for a security with a maturity of n
) 1 ( ) 1 ( ) 1 (
1
1 n
n
n
n
n
f y y + + = +

Forward Rates from

Observed Rates
AFF5040-L07 21
Forward Rates for Downward
Sloping Y C Example
1yr Forward Rates


1yr [(1.1175)
2
/ 1.12] - 1 =0.115006
2yrs [(1.1125)
3
/ (1.1175)
2
] - 1 = 0.102567
3yrs [(1.1)
4
/ (1.1125)
3
] - 1 = 0.063336
4yrs [(1.0925)
5
/ (1.1)
4
] - 1 = 0.063008

Zero-Coupon Rates Bond Maturity
12% 1
11.75% 2
11.25% 3
10.00% 4
9.25% 5
4 yr spot = 8.00%, 3yr = 7.00% f
4
= ?
(1.08)
4
= (1.07)
3
(1+f
n
)
(1.3605) / (1.2250) = (1+f
n
)
f
4
= .1106 or 11.06%
AFF5040-L07 22
Example 15.4
Interest Rate
Uncertainty
What can we say when future interest rates are
not known today
Suppose that todays rate is 5% and the expected
short rate for the following year is E(r
2
) = 6%
then:

For a one year investor, the rate of return on the
2-year bond is risky because if next years
interest rate turns out to be above expectations,
the price will lower and vice versa

2
2 1 2
(1 ) (1 ) [1 ( )] 1.05 1.06 y r x E r x + = + + =
AFF5040-L07 23
Interest Rate Uncertainty
The investor wants to invest for 1 year.
Buy the 2-year bond today and plan to sell it at
the end of the first year for $1000/1.06 =$943.40.
0r
Buy the 1-year bond today and hold to maturity.
What if next years interest rate is more (or less)
than 6%?
The actual return on the 2-year bond is uncertain!


AFF5040-L07 24
Interest Rate
Uncertainty Continued
Investors require a risk premium to hold a
longer-term bond
This liquidity premium compensates short-term
investors for the uncertainty about future prices
AFF5040-L07 25
Expectations Theory
Observed long-term rate is a function of todays
short-term rate and expected future short-term
rates
Long-term and short-term securities are perfect
substitutes
Forward rates that are calculated from the yield
on long-term securities are market consensus
expected future short-term rates
AFF5040-L07 26
Liquidity Premium
Theory
Long-term bonds are more risky
Investors will demand a premium for the risk
associated with long-term bonds
The yield curve has an upward bias built into the
long-term rates because of the risk premium
Forward rates contain a liquidity premium and
are not equal to expected future short-term
rates
AFF5040-L07 27
Yield Curves
(Concluded)
Five-year Spot Rate:

Five-year Forward Rate:

AFF5040-L07 28
Figure 15.4 Yield
Curves

Interpreting the Term
Structure
The yield curve reflects expectations of future
interest rates.
The forecasts of future rates are clouded by other
factors, such as liquidity premiums.
An upward sloping curve could indicate:
Rates are expected to rise
And/or
Investors require large liquidity premiums to hold
long term bonds.
AFF5040-L07 30
Interpreting the Term Structure
The yield curve is a good predictor of the
business cycle.
Long term rates tend to rise in anticipation of
economic expansion.
Inverted yield curve may indicate that interest
rates are expected to fall and signal a recession.

31
Term Spread: Yields on 10-year vs.
90-day Treasury Securities
32
Forward Rates as
Forward Contracts
In general, forward rates will not equal the eventually
realized short rate
Still an important consideration when trying to make
decisions:
Locking in loan rates
If the yield curve is to rise as one moves to longer maturities
A longer maturity results in the inclusion of a new forward
rate that is higher than the average of the previously
observed rates
Reason:
Higher expectations for forward rates or
Liquidity premium
AFF5040-L07 33
Engineering a Synthetic
Forward Loan
In year
0

Buy a 1 year zero in Y
0

Sell 1+f
2
*( 2 year zero)
Initial cash position =0
Collect in year
1
(loan)
Repay loan in year
2
AFF5040-L07 34
SUMMARY

Determination of Forward and
Futures Prices
Hull Chapter 5 and 6 (parts)

Short Selling (Page 102-103)
(recap)
Short selling involves selling securities you
do not own
Your broker borrows the securities from
another client and sells them in the market
in the usual way
AFF5040-L07 37
Notation for Valuing Futures
and Forward Contracts
S
0
: Spot price today
F
0
: Futures or forward price today
T: Time until delivery date
r: Continuous risk-free interest
rate for maturity T
AFF5040-L07 38
1. An Arbitrage
Opportunity?
Suppose that:
The spot price of a US non-dividend
paying stock is $40
The 3-month forward price is $43
The 3-month US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
AFF5040-L07 39
2. Another Arbitrage
Opportunity?
Suppose that:
The spot price of a US non-dividend
paying stock is $40
The 3-month forward price is US$39
The 3-month US$ interest rate is 5%
per annum
Is there an arbitrage opportunity?
AFF5040-L07 40
The Forward Price
If the spot price of an investment asset is S
0
and the
futures price for a contract deliverable in T years is
F
0
, then
F
0
= S
0
e
rT

where r is the 1-year risk-free rate of interest
quoted continuously.
In our examples, S
0
=40, T=0.25, and r=0.05 so that
F
0
= 40e
0.050.25
= 40.50
AFF5040-L07 41
Arbitrage Possibilities
If spot-futures parity is not observed, then
arbitrage is possible
If the futures price is too high, short the futures
and acquire the stock by borrowing the money at
the risk free rate
If the futures price is too low, go long futures,
short the stock and invest the proceeds at the
risk free rate
42 AFF5040-L07

When an Investment Asset
Provides a Known Dollar Income
F
0
= (S
0
I )e
rT


where I is the present value of the income during
life of forward contract
AFF5040-L07 43
When an Investment Asset
Provides a Known Yield
F
0
= S
0
e
(rq )T


where q is the average yield during the life of the
contract (expressed with continuous compounding)
AFF5040-L07 44
Valuing a Forward Contract
Page 110
Suppose that
K is delivery price in a forward contract and
F
0
is forward price that would apply to the
contract today
The value of a long forward contract, , is
= (F
0
K )e
rT

Similarly, the value of a short forward contract is
(K F
0
)e
rT
AFF5040-L07 45
Forward vs Futures Prices
Forward and futures prices are usually assumed to
be the same. When interest rates are uncertain they
are, in theory, slightly different:
A strong positive correlation between interest rates
and the asset price implies the futures price is
slightly higher than the forward price
A strong negative correlation implies the reverse
AFF5040-L07 46
Stock Index
Can be viewed as an investment asset paying a
dividend yield
The futures price and spot price relationship is
therefore
F
0
= S
0
e
(rq )T

where q is the average dividend yield on the
portfolio represented by the index during life of
contract
AFF5040-L07 47
Stock Index
(continued)
For the formula to be true it is important that the
index represent an investment asset
In other words, changes in the index must
correspond to changes in the value of a tradable
portfolio
The Nikkei index viewed as a dollar number does
not represent an investment asset (See Hull
Business Snapshot 5.3, page 113)
AFF5040-L07 48
Index Arbitrage
When F
0
> S
0
e
(r-q)T
an arbitrageur buys the stocks
underlying the index and sells futures
When F
0
< S
0
e
(r-q)T
an arbitrageur buys futures and
shorts or sells the stocks underlying the index

AFF5040-L07 49
Index Arbitrage

Index arbitrage involves simultaneous trades in futures and
many different stocks
Very often a computer is used to generate the trades
Occasionally simultaneous trades are not possible and the
theoretical no-arbitrage relationship between F
0
and S
0
does
not hold (see Business Snapshot 5.4 on page 114)

AFF5040-L07 50
Futures and Forwards on
Currencies (Page 114-117)
A foreign currency is analogous to a security
providing a dividend yield
The continuous dividend yield is the foreign risk-free
interest rate
It follows that if r
f
is the foreign risk-free interest
rate

F S e
r r T
f
0 0
=
( )
AFF5040-L07 51
Why the Relation Must Be
True
1000 units of
foreign currency
at time zero
units of foreign
currency at time T
T r
f
e 1000
dollars at time T
T r
f
e F
0
1000
1000S
0
dollars
at time zero
dollars at time T
rT
e S
0
1000
1000 units of
foreign currency
at time zero
units of foreign
currency at time T
T r
f
e 1000
dollars at time T
T r
f
e F
0
1000
1000S
0
dollars
at time zero
dollars at time T
rT
e S
0
1000
AFF5040-L07 52
Futures on Consumption
Assets
Consumption assets have storage costs:
F
0
s S
0
e
(r+u )T

where u is the storage cost per unit time as a percent
of the asset value.
Alternatively,
F
0
s (S
0
+U )e
rT

where U is the present value of the storage costs.

AFF5040-L07 53
The Cost of Carry (Page 120)
The cost of carry, c, is the storage cost plus the
interest costs less the income earned
For an investment asset F
0
= S
0
e
cT

For a consumption asset F
0
s S
0
e
cT

The convenience yield on the consumption asset, y,
is defined so that F
0
= S
0
e
(cy )T

AFF5040-L07 54
Futures Prices & Expected
Future Spot Prices
Suppose k is the expected return required by
investors on an asset
We can invest F
0
e
r T
at the risk-free rate and enter
into a long futures contract so that there is a cash
inflow of S
T
at maturity
This shows that




T k r
T
T
kT rT
e S E F
S E e e F
) (
0
0
) (
or
) (

=
=
AFF5040-L07 55
Futures Prices & Future Spot
Prices (continued)
If the asset has
no systematic risk, then k = r and F
0
is an unbiased
estimate of S
T

positive systematic risk, then k > r and F
0
< E (S
T
)
negative systematic risk, then k < r and F
0
> E (S
T
)
AFF5040-L07 56
Treasury Bond Price Quotes
in the U.S
Cash price = Quoted price + Accrued Interest

Cash price received by party with short position =
Most recent settlement price Conversion factor*
+ Accrued interest

*The conversion factor for a bond is approximately equal to the value
of the bond on the assumption that the yield curve is flat at 6% with
semiannual compounding
AFF5040-L07 57
Example
Most recent settlement price = 90.00
Conversion factor of bond delivered = 1.3800
Accrued interest on bond =3.00
Price received for bond is 1.380090.00+3.00 =
$127.20
per $100 of principal

AFF5040-L07 58
Australian Bond Futures
Price quoted as 100 yield
Based on $100,000 face value bond with 6% coupon
For example, if yield is 4%, futures price is 100 4 = 96.000
Cash settlement
ASX chooses benchmark bond and obtains random quotes
from active dealers to determine closing yield and hence
price
Open positions settled at that price

59 AFF5040-L07
A Eurodollar is a dollar deposited in a bank outside the
United States
Eurodollar futures are futures on the 3-month Eurodollar
deposit rate (same as 3-month LIBOR rate)
One contract is on the rate earned on $1 million
A change of one basis point or 0.01 in a Eurodollar futures
quote corresponds to a contract price change of $25
A Eurodollar futures contract is settled in cash
When it expires (on the third Wednesday of the delivery
month) the final settlement price is 100 minus the actual
three month deposit rate

Eurodollar Futures (Page
136-142)
AFF5040-L07 60
Example
Suppose you buy [take a long position in] a contract
on November 1
The contract expires on December 21
The prices are as shown
How much do you gain or lose a) on the first day, b)
on the second day, c) over the whole time until
expiration?
AFF5040-L07 61
Example
Date Quote
Nov 1 97.12
Nov 2 97.23
Nov 3 96.98
.
Dec 21 97.42
AFF5040-L07 62
Example continued
If on Nov. 1 you know that you will have $1 million
to invest on for three months on Dec 21, the
contract locks in a rate of
100 - 97.12 = 2.88%
In the example you earn 100 97.42 = 2.58% on $1
million for three months (=$6,450) and make a gain
day by day on the futures contract of 30$25 =$750
If Q is the quoted price of a Eurodollar futures
contract, the value of one contract is 10,000[100-
0.25(100-Q)]
AFF5040-L07 63
SUMMARY
Australian Govt. Bond Issue
recent tender
4 April 2012
Series Offered
4.25% 21 July
2017
Offered to Public ($million) 700
Reserve Bank Take-up ($million) -
Total Amount Offered ($million) 700
Amount Allotted to Public ($million) 700
Weighted Average Issue Yield (%) 3.6686
Lowest Yield Accepted (%) 3.665
Highest Yield Accepted (%) 3.675
Amount Allotted at Highest Accepted Yield as
Percentage of Amount Bid at that Yield*
10
Coverage Ratio 2.74
*Individual allotments may vary due to rounding.