Interest Rate Markets

Chapter 5
Chapter Outline
5.1 Types of Rates
5.2 Zero Rates
5.3 Bond Pricing
5.4 Determining zero rates
5.5 Forward rates
5.6 Forward rate agreements
5.7 Theories of term structure
5.8 Day count conventions
Chapter Outline
5.9 Quotations
5.10 Treasury Bond Futures
5.11 Eurodollar futures
5.12 The LIBOR zero curve
5.13 Duration
5.14 Duration-based hedging strategies
5.1 Types of Rates
Treasury rates
LIBOR rates
Repo rates
5.2 Zero Rates
A zero rate (or spot rate), for maturity T is the rate of
interest earned on an investment that provides a
payoff only at time T

Example (Table 5.1, page 95)

Maturity
(years)
Zero Rate
(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
5.3 Bond Pricing
To calculate the cash price of a bond we discount each cash
flow at the appropriate zero rate
In our example, the theoretical price of a two-year bond
providing a 6% coupon semiannually is


3 3 3
103 9839
0 05 0 5 0 058 1 0 0 064 1 5
0 068 2 0
e e e
e


+ +
+ =
. . . . . .
. .
.
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. aka YTM
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39
The bond yield is given by solving

to get y=0.0676 or 6.76%.

3 3 3 103 9839
0 5 1 0 15 2 0
e e e e
y y y y
+ + + =
. . . .
.
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


g) compoundin s.a. (with 87 6 get to
100
2
100
2 2 2
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
. c=
e
c
e
c
e
c
e
c
=
|
.
|

\
|
+ +
+ +


Par Yield continued
In general if
m is the number of coupon payments per year,
d is the present value of $1 received at maturity and
A is the present value of an annuity of $1 on each
coupon date

A
m d
c
) 100 100 (
=
5.4 Determining Treasury Zero Rates
Treasury zero rates can be calculated from the
prices of instruments that trade.
One way to do this is the bootstrap method.
To see how this works, consider the following
example:
Sample Data for Determining the Zero Curve (Table
5.2, page 97)

Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
Half the stated coupon is paid every 6 months.
An amount 2.5 can be
earned on 97.5 during 3
months.
The 3-month rate is 4
times 2.5/97.5 or
10.256% with quarterly
compounding
This is 10.127% with
continuous
compounding
The Bootstrapping the Zero Curve
Similarly the 6 month and 1 year rates are 10.469%
and 10.536% with continuous compounding

Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
The Bootstrap Method continued
To calculate the 1.5 year rate we solve


to get R = 0.10681 or 10.681%

96 104 4 4
5 . 1 0 . 1 10536 . 0 5 . 0 10469 . 0
= + +
R
e e e
Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 1.50 8 96.0
100 2.00 12 101.6
Similarly the two-year rate is 10.808%
Zero Curve Calculated from the Data (Figure
5.1, page 98)

9
10
11
12
0 0.5 1 1.5 2 2.5
Zero
Rate (%)
Maturity (yrs)
10.127
10.469 10.536
10.681
10.808
5.5 Forward Rates

The forward rate is the future zero rate implied by
todays term structure of interest rates
Calculation of Forward Rates
Table 5.4, page 98

Zero Rate for Forward Rate
an n -year Investment for n th Year
Year ( n ) (% per annum) (% per annum)
1 10.0
2 10.5 11.0
3 10.8 11.4
4 11.0 11.6
5 11.1 11.5
2 105 . 21 . 11 . 1 .
100 100 100

= = e e e e
Formula for Forward Rates
Suppose that the zero rates for maturities T
1
and T
2

are R
1
and R
2
with both rates continuously
compounded.
The forward rate for the period between times T
1

and T
2
is


R T RT
T T
2 2 1 1
2 1

Instantaneous Forward Rate

The instantaneous forward rate for a maturity T is
the forward rate that applies for a very short time
period starting at T. It is


where R is the T-year rate
R T
R
T
+
c
c
Upward vs. Downward Sloping
Yield Curve
For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield

For a downward sloping yield curve
Par Yield > Zero Rate > Fwd Rate
Forward Rate Agreement
A forward rate agreement (FRA) is an agreement
that a certain rate will apply to a certain principal
during a certain future time period
Forward Rate Agreement
continued (Page 100)
An FRA is equivalent to an agreement where
interest at a predetermined rate, R
K
is exchanged for
interest at the market rate
An FRA can be valued by assuming that the
forward interest rate is certain to be realized
We can make arbitrage arguments
Theories of Term Structure
Maturity
5 10 15
Liquidity Preference
Upward bias over expectations
Fails to explain downward sloping yield curve
Market Segmentation
Preferred Habitat
Explains both
downward and upward
sloping yield curves
D
5
D
10
D
15
S
5
S
10
S
15
Expectations
D
5
D
10
D
15
S
10
S
15
S
5
Day Count Conventions
in the U.S. (Pages 102-103)

Treasury Bonds:
Corporate Bonds:
Money Market Instruments:

Actual/Actual (in period)
30/360
Actual/360

The interest earned between two dates is:
period reference in earned interest
period reference in days of number
dates between days of number

5.9 Treasury Bond Price Quotes in the U.S

Cash price = Quoted price + Accrued Interest since
last coupon date

Treasury Bill Quote in the U.S.
If Y is the cash price of a Treasury bill that has n
days to maturity the quoted price is

360
100
n
Y ( )
This is referred to as the discount rate


5.10 Treasury Bond Futures
Page 104

Cash price received by party with short position =
Quoted futures price Conversion factor + Accrued
interest
Each contract is for the delivery of $100,000 face value
of bonds.
Suppose the quoted futures price is 90-00, the conversion factor
is 1.3800 and the accrued interest at the time of delivery is $3
per $100 of face value:
901.38 + 3.00 = $127.2 per $100 of face value or $127,200
Conversion Factor
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
CBOT
T-Bonds & T-Notes

Factors that affect the futures price:
Delivery can be made any time during the
delivery month
Any of a range of eligible bonds can be
delivered
The wild card play
If Z is the quoted price of a Eurodollar futures
contract, the value of one contract is
10,000[100-0.25(100-Z)]
A change of one basis point or 0.01 in a Eurodollar
futures quote corresponds to a contract price change
of $25
5.11 Eurodollar Futures (Page 110)
Eurodollar Futures continued
A Eurodollar futures contract is settled in cash
When it expires (on the third Wednesday of the
delivery month) Z is set equal to 100 minus the 90
day Eurodollar interest rate (actual/360) and all
contracts are closed out
Forward Rates and Eurodollar Futures (Page
111)
Eurodollar futures contracts last out to 10 years
For Eurodollar futures we cannot assume that the
forward rate equals the futures rate
Forward Rates and Eurodollar Futures
continued
A " convexity adjustment" often made is
Forward rate =Futures rate
where is the time to maturity of the
futures contract, is the maturity of
the rate underlying the futures contract
(90 days later than ) and is the
standard deviation of the short rate changes
per year (typically is about

1
2
0 012
2
1 2
1
2
1
o
o
o
t t
t
t
t
. )
Duration of a bond that provides cash flow c
i
at time t
i

is



where B is its price and y is its yield (continuously
compounded)
This leads to

t
c e
B
i
i
n
i
yt
i
=

(
1
y D
B
B
o =
o
Duration
Duration Continued
When the yield y is expressed with compounding
m times per year


The expression


is referred to as the modified duration

m y
y BD
B
+
o
= o
1
D
y m 1+
Convexity
The convexity of a bond is defined as
C
B
B
y
c t e
B
B
B
D y C y
i i
yt
i
n
i
= =
= +

1
1
2
2
2
2
1
2
c
c
o
o o
so that
( )
Duration Matching
This involves hedging against interest rate risk by
matching the durations of assets and liabilities
It provides protection against small parallel shifts in
the zero curve
5.14 Duration-based hedging strategies

Hedging in Interest Rate Futures
A mortgage lender who has agreed to loan
money in the future at prices set today can
hedge by selling those mortgages forward.
It may be difficult to find a counterparty in
the forward who wants the precise mix of
risk, maturity, and size.
Its likely to be easier and cheaper to use
interest rate futures contracts however.

Duration Hedging
As an alternative to hedging with futures or
forwards, one can hedge by matching the
interest rate risk of assets with the interest
rate risk of liabilities.
Duration is the key to measuring interest rate
risk.
Duration measures the combined effect of
maturity, coupon rate, and YTM on bonds
price sensitivity
Measure of the bonds effective maturity
Measure of the average life of the security
Weighted average maturity of the bonds cash
flows
Duration Hedging
Duration Formula

=
=
+
+

=
+ + +
=
N
t
t
t
N
t
t
t
T
r
C
r
t C
D
PV
T C PV C PV C PV
D
1
1
2 1
) 1 (
) 1 (
) ( 2 ) ( 1 ) (
Calculating Duration
Calculate the duration of a three-year bond that
pays a semi-annual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually.
Discount Present Years x PV
Years Cash flow factor value / Bond price
0.5 $40.00 0.96154 $38.46 0.0192
1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Calculating Duration
Duration is expressed in units of time; usually years.
Duration
The key to bond portfolio management
Properties:
Longer maturity, longer duration
Duration increases at a decreasing rate
Higher coupon, shorter duration
Higher yield, shorter duration
Zero coupon bond: duration = maturity
5.25
On August 1 a portfolio manager has a bond
portfolio worth $14 million. The duration of the
portfolio in October will be 7.1 years.
The December Treasury bond futures price is
currently 91-12 and the cheapest-to-deliver bond
will have a duration 0f 8.8 years at maturity
How should the manager immunize the portfolio
against changes in interest rates over the next two
months?
5.25
The treasurer should short Treasury bond futures
contract.
If bond prices go down, this futures position will
provide offsetting gains.
The number of contracts that should be shorted is
3 . 88
8 . 8 375 , 91
1 . 7 000 , 10
=