BM FI6051 WK9 Lecturer Notes

Financial Derivatives
FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009
Week 9 – Fixed Income

Bonds
 On a point of interest, the cover slide shows a US
Government Bond, 4¼% Coupon Issused in
1933. Unusually, there are unused coupons
attached
 Bonds are still issued by governments,

municipalities, semi-state bodies and corporate
institutions. Actual certificates are now rarely
issued and the coupons are not attached to the
bond. This is all done electronically but the
principals are the same
Types of Interest Rates
 Treasury Rates
 The interest rates applicable to the borrowings of a
government denominated in its own currency
 For example, US Treasury rates apply to the borrowings
of the US government denominated in US dollars
 Such debt instruments include T-bills (money markets),
and T-Notes and T-bonds (capital markets)
 Given that negligible default risk applies to
governmental debt, Treasury rates tend to be very low
 Treasury rates are often used as a proxy for risk-free
interest rates
Source: Reuters 15/09/05

Source: Reuters 15/09/05

 LIBOR Rates
 Large international banks transfer funds between each
other by means of 1-, 3-, 6-, and 12-month deposits
 The deposits can be denominated in any of the world’s
major currencies
 Each international bank quotes bid and offer rates for
such interbank transfers of funds
 The bid (offer) is the rate at which an international bank
is willing to accept (advance) deposits
 The bid rate is referred to as the London Interbank Bid
Rate or LIBID
 The offer rate is referred to as the London Interbank
Offer Rate or LIBOR
 LIBOR rates tend to be slightly higher than
corresponding Treasury rates
 The reason for this is the LIBOR rates, unlike Treasury
rates, are not considered to be entirely risk-free
 LIBOR rates however do tend to be very low due to the
low default risk involved in the interbank deposits
 Therefore, LIBOR rates are often used as a proxy for
risk-free interest rates
 Repo Rates
 A repo is an agreement involving the sale of securities
by one party to another with a promise to repurchase at
a specified price and on a specified date in the future
 The underlying securities to repos are primarily Treasury
and government agent instruments
 The repo allows short-term returns on excess funds,
where the securities form a source of collateral
 The difference between the sale and repurchase prices
represents the interest earned on the repo
 The level of interest on the repo is referred to as the
repo rate
Zero Rates
 Zero rates or zero-coupon rates refer to the
interest rates applying to investments that
continue for some specified term
 The n-year zero rate is the interest rate that

applies to an n-year investment
 All interest and principal is realized at the expiry

of the investment, i.e. no intermediate payments
 For instance, consider a 5% zero rate on a 5-year

investment initiated at $100
Zero Rates
 The terminal value of the investment is $128.40,
i.e. 0.05 ( 5 )
100e = 128.40
 In the markets many of the interest rates

observed are not pure zero rates
 Many instruments for example offer coupon payments
which are paid prior to expiry
 It is however possible to determine zero rates

from the prices of such coupon-bearing
instruments
Bond Pricing
 Bonds are long-term debt obligations issued by
corporations and governments
 Funds raised are generally used to support large-scale
and long-term expansion and development
 Bonds are financial instruments designed to:

 Repay the original investment principal at a pre-
specified maturity date
 Make periodic coupon interest payments over the life of
the investment period
 The theoretical price of a bond involves summing

the present value of all resulting cash flows
Bond Pricing
 Given that the cash flows occur at different points
in time, appropriate zero-rates are used for the
discounting
 To illustrate, consider the following Treasury zero

rates
Maturity (Years) Zero Rate (%)
0.5 5.0
1 5.8
1.5 6.4
2 6.8
Bond Pricing
Treasury Zero Curve
8
7
6
5
Yield (%)
4
3
2
1
0
0.5 1 1.5 2
Years
Bond Pricing
 Consider a 2-year Treasury bond with a face
value of $100 and a coupon rate of 6% paid
semi-annually
 The coupon payment on the bond is $3, which is

determined as follows
Pf × rc 100( 0.06 )
= =3
m 2
where
Pf ≡ the face value of the bond
rc ≡ the coupon rate on the bond
m ≡ the (per year) payment frequency of the coupon
Bond Pricing
 The following table details all the cash flows on
the bond, along with the present value of each
Payment Date Cash Flow Present Value of
(Years) Cash Flow
0.5 3 3e-0.05(0.5)
1 3 3e-0.058(1)
1.5 3 3e-0.064(1.5)
2 103 103e-0.068(2)
 Note that the appropriate discount rates used for

the PV calculations above are the zero rates given
previously
Bond Pricing
 Therefore the price of the bond under
consideration is $98.39, i.e.
−0.05 ( 0.5 ) −0.058 ( 1) −0.064 ( 1.5 ) −0.068 ( 2 )
3e + 3e + 3e + 103e = 98.39
Bond Yield
 The yield or yield-to-maturity on a coupon-
bearing bond is the rate that equates all cash
flows to its market value
 Let y denote the yield on a bond, and take the

bond considered previously
 The yield y on the bond may be determined by

solving the following equation
− y ( 0.5 ) − y ( 1) − y ( 1.5 ) − y( 2)
3e + 3e + 3e + 103e = 100
Bond Yield
 The solution to the above equation is non-trivial
and requires a numerical search routine such as
Newton-Raphson
 The solution gives a value for the bond yield of

6.76%, i.e. y = 6.76%
Determining Treasury Zero Rates
 Treasury zero rates can be calculated from the
prices of traded debt instruments
 One common method of determining the interest

rates is that of bootstrapping
 Consider 5 separate bonds, 3 of which are zero-

coupon and 2 of which are coupon-bearing
 Details of the bonds are given in the next table

Face Value Maturity Annual Coupon Bond Price
(Years) (Semi-Annual Payment)
100 0.25 0 97.50
100 0.5 0 94.90
100 1 0 90.00
100 1.5 8 96.00
100 2 12 101.60
 The zero rates for the 3 zero-coupon bonds can

be calculated easily
 For this note that the zero rate on a zero-coupon
bond is given by the following formula
Pf − P0 1
×
Po T
where
Pf ≡ the face value of the bond
P0 ≡ the current market price of the bond
T ≡ the term-to-maturity of the bond
 Note that the above formula gives zero rates

using (1/T)-period compounding
 That is, discrete compounding rather than continuous
compounding
 In order to express these zero rates using
continuous compounding the following formula is
used
 Rm 
Rc = m ln1 + 
 m 
where
Rc ≡ the rate of interest with continous compounding
Rm ≡ the rate of interest with discrete compounding
m ≡ the compounding frequency of Rm per annum
 The above formulas will be illustrated with the

first zero-coupon bond
 The term-to-maturity of the zero-coupon bond is
T = 0.25
 So the zero rate associated with the bond is for

quarterly compounding since
1
m= =4
T
 Therefore, the 3-month zero rate with quarterly
compounding is
100 − 97.5
R4 = × 4 = 10.256%
97.5
 The conversion of R4 to the corresponding zero
rate with continuous compounding is calculated
as follows
 0.10256 
Rc = 4 ln1 +  = 0.10127 = 10.127%
 4 
 Note now that the term-to-maturity of the second

zero-coupon bond is T = 0.5
 So the zero rate associated with the bond is for

semi-annual compounding since m = 1 = 2
T
 Therefore, the 6-month zero rate with semi-
annual compounding is
100 − 94.9
R2 = × 2 = 10.748%
94.9
 The conversion of R2 to the corresponding zero

rate with continuous compounding is calculated
as follows
 0.10748 
Rc = 2 ln1 +  = 0.10469 = 10.469%
 2 
 In the same way, it can be shown that for the
third zero-coupon bond that Rc = 10.536%
 Consider now the first coupon-bearing bond

presented in the bond data previously
 The term-to-maturity of this bond is one and a

half years, i.e. T = 1.5
 The next table details all the cash flows resulting

from this bond
Payment Date Cash Flow
(Years)
0.5 4
1 4
1.5 104
 From the work done so far the 6-month and 1-

year zero rates have already been calculated, i.e.
Rc ,0.5 = 10.469%
Rc ,1 = 10.536%
 So the 1.5-year zero rate can be determined by
the solving the following pricing relation
−0.10469 ( 0.5 ) −0.10536 ( 1) − Rc ,1.5 ( 1.5 )
4e + 4e + 104e = 96
 Solving for Rc,1.5 proceeds as follows

96 − 4e −0.10469( 0.5 ) − 4e −0.10536( 1)
− Rc ,1.5 ( 1.5 )
e = = 0.85196
104
⇒ − Rc ,1.5 (1.5) = ln ( 0.85196)
ln( 0.85196)
⇒ Rc ,1.5 =− = 0.10681 = 10.681%
1. 5
 Consider now the second coupon-bearing bond
presented in the bond data previously
 The term-to-maturity of this bond is two years,

i.e. T = 2
 The table below details all the cash flows from

this bond Payment Date (Years) Cash Flow
0.5 6
1 6
1.5 6
2 106
 From the work done so far it is known that
Rc , 0.5 = 10.469%
Rc ,1 = 10.536%
Rc ,1.5 = 10.681%
 So the 2-year zero rate can be determined by the

solving the following pricing relation
6e −0.10469( 0.5 ) + 6e −0.10536( 1)

− 0.10681( 1.5 ) − Rc , 2 ( 2 )
+ 6e + 106e = 101.6
 Solving for Rc,2 is straightforward and proceeds as
follows
− Rc , 2 ( 2 )
e = 0.8056
⇒ − Rc , 2 ( 2 ) = ln ( 0.8056 )
ln ( 0.8056 )
⇒ Rc ,1.5 =− = 0.10808 = 10.808%
2
 The next table summarizes the zero rates

calculated under the bootstrap method
0.25 10.127
0.5 10.469
1 10.536
1.5 10.681
2 10.808
 The following diagram is a graph of the zero rate

curve given the rates tabulated above
12
11
10.68 10.808
10 10.469 10.53 1
6
10.127
9
0 0.5 1 1.5 2 2.5
Maturity (yrs)
Forward Rates
 Forward Interest Rate
 A Forward Interest Rate is an interest rate
which is specified now for a loan that will occur
at a specified future date
 As with current interest rates, forward interest
rates include a term structure which shows the
different forward rates offered to loans of
different maturities.
Forward Rates
 Forward rates are those rates implied by current
zero rates for periods of time in the future
 Consider two zero rates Rx and Ry, with maturities

Tx and Ty respectively (Ty > Tx)
 Let RF denote the forward rate for the period of

time between Tx and Ty
 RF can be calculated from the two zero rates

using the following general formula
Forward Rates
R y T y − R x Tx
RF =
T y − Tx
 We can quickly derive this from first principles
 Assume the 3month EURIBOR Rate is 4.1%
 And the 6month EURIBOR Rate is 4.3%
 We can say that:
(100e ( 0.25 )( 0.041)

)e RF ( 0.5 − 0.25 )
= 100e ( 0.043)( 0.5 )
 Now, derive the equation above!
We are assuming continuously compounded rates

Forward Rates
 To illustrate further, consider the following zero
rate data

1 10
2 10.5
3 10.8
4 11
5 11.1
We are assuming continuously compounded rates

Forward Rates
7
Treasury Zero Curve
Ry
6.5
6
Yield (%)
5.5Rx
4.5
Tx
4
0.5 1 Years 1.5 2
Ty
Forward Rates
 Let RF1, 2 denote the forward rate for the period
between year 1 and year 2
 According to the general formula

R2 ( 2 ) − R1 (1)
R F1, 2 =
2 −1
= 0.105( 2) − 0.10(1)
= 0.11 = 11%
 Similarly let R F2 , 3 denote the forward rate for the

period between year 2 and year 3
Forward Rates
 The general forward rate formula gives
R3 ( 3) − R2 ( 2 )
RF2 , 3 =
3− 2
= 0.108( 3) − 0.105( 2 )
= 0.114 = 11.4%
 In the same way it is possible to calculate the 1-

year forward rates for the 4th and 5th years under
consideration
 The next table presents all the forward rates

Forward Rates
Maturity (Years) Zero Rate (%) Forward Rates
(for n-th year)
1 10
2 10.5 11
3 10.8 11.4
4 11 11.6
5 11.1 11.5
 By rewriting the general forward rate formula it is

possible to establish important relationships
between zero and forward rates
Forward Rates
Forward Curve
12
11.5
11
10.5
Yield (%)
10
9.5
Zero-Rate Forward-Rate
9
8.5
8
1 2 Years 3 4 5
Forward Rates
 The general forward rate formula can be
rewritten as follows
RF = R y + ( R y − Rx )
Tx
T y − Tx
 If the zero curve is upward sloping, i.e. Ry>Rx,

then from the relation above RF>Ry
 If the zero curve is downward sloping, i.e. Ry<Rx,

then from the relation above RF<Ry
Forward Rates
 Taking limits as Ty approaches Tx leads to the
following relationship
∂R
RF = R + T
∂T
 In the above equation R is the zero rate for a

maturity of T
 And RF is referred to as the instantaneous forward

rate at time T
 That is, the forward rate that applies to an infinitesimal
time period beginning at time T
Forward Rate Agreements (FRAs)
 A Forward Rate Agreement (FRA) is a bilateral or
‘over the counter’ (OTC) interest rate contract in
which two counterparties agree to exchange the
difference between an agreed interest rate and
an as yet unknown reference rate of specified
maturity that will prevail at an agreed date in the
future.
 Payments are calculated against a pre-agreed

notional principal
 The reference rate is typically LIBOR or EURIBOR
 Consider a FRA that is agreed between two
parties with an interest rate of RK applying
between times T1 and T2 (T2 > T1)
 The interest rate RK applies to some principal L

 Let R1 and R2 denote the zero rates applying to
the maturities T1 and T2 respectively
 The next table illustrates the cash flows resulting

from the FRA
Date Cash Flow
T1 -L
T2 + L{exp[RK(T2-T1)]}
 The value of the agreement at time 0, V(0), can

be found by taking the present value of these
cash flows
7
TreasuryZero Curve
R2
6.5
6
Yield (%)
R1
5.5
4.5
4
0.5 1 Years 1.5 2
T1 T2
 Lends (Pays)
FRA Buyer Receives
where L at LT2atplus
T1 interest between
 What
T is L worth today?
1 & T2 2 − at
R2TI.e. R1TT(0)?
R K = 1
 = Le-R isT this worth
What 1 1
T2 −I.e.
today? T1 at T(0)?
 = e-R T (Le-R (T -T )) )
2 2 k 2 1
 Therefore, V(0) is as follows
− R1T1 RK ( T2 −T1 ) − R2T2
V (0) = − Le + Le e
 From this it can be noted that V(0) = 0 when
− R1T1 = RK ( T2 − T1 ) − R2T2
R2T2 − R1T1
⇒ RK =
T2 − T1
 The equation for RK above corresponds to the
general forward rate equation from the last
section
 So the initial value of a FRA is zero when the

agreed rate RK is set equal to the corresponding
forward rate RF
 Forward Rate Agreements are usually settled at
T1 (rather than T2)
 A FRA is agreed on a notional amount of €100MM

 The agreed Forward Rate (RK) is 4.5% between
18months and 2years
 Let RM equal the actual six month spot rate in
18months time
 At T1 (in 18 months), the parties to the FRA agree
to settle the trade as RM is known at that point
 According to the agreement, the lender receives
100MM(e(R -R )(T -T )-1) at T2
K M 2 1
 As the agreement is settled at T1, the lender

receives 100MM(e(R -R )(T -T )-1).e(- R )(T -T )
K M 2 1 M 2 1
 Note that the lender can lose money

 Use examples to confirm these cash flows
Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2005, 6th Ed.
 Chapter 4
Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2005, 6th Ed.
 Chapter 4

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Financial Derivatives

Week 9 – Fixed Income

 Bonds are still issued by governments,

Source: Reuters 15/09/05

Source: Reuters 15/09/05

 The n-year zero rate is the interest rate that

 All interest and principal is realized at the expiry

 For instance, consider a 5% zero rate on a 5-year

 In the markets many of the interest rates

 It is however possible to determine zero rates

 Bonds are financial instruments designed to:

 The theoretical price of a bond involves summing

 To illustrate, consider the following Treasury zero

Treasury Zero Curve

 The coupon payment on the bond is $3, which is

 Note that the appropriate discount rates used for

 Let y denote the yield on a bond, and take the

 The yield y on the bond may be determined by

 The solution gives a value for the bond yield of

 One common method of determining the interest

 Consider 5 separate bonds, 3 of which are zero-

 Details of the bonds are given in the next table

100 0.5 0 94.90

100 1.5 8 96.00

 The zero rates for the 3 zero-coupon bonds can

 Note that the above formula gives zero rates

 The above formulas will be illustrated with the

 So the zero rate associated with the bond is for

 Note now that the term-to-maturity of the second

 So the zero rate associated with the bond is for

 The conversion of R2 to the corresponding zero

 Consider now the first coupon-bearing bond

 The term-to-maturity of this bond is one and a

 The next table details all the cash flows resulting

 From the work done so far the 6-month and 1-

 Solving for Rc,1.5 proceeds as follows

 The term-to-maturity of this bond is two years,

 The table below details all the cash flows from

 So the 2-year zero rate can be determined by the

6e −0.10469( 0.5 ) + 6e −0.10536( 1)

 The next table summarizes the zero rates

 The following diagram is a graph of the zero rate

 Consider two zero rates Rx and Ry, with maturities

 Let RF denote the forward rate for the period of

 RF can be calculated from the two zero rates

(100e ( 0.25 )( 0.041)

 Now, derive the equation above!

We are assuming continuously compounded rates

Maturity (Years) Zero Rate (%)

We are assuming continuously compounded rates

 According to the general formula

 Similarly let R F2 , 3 denote the forward rate for the

 In the same way it is possible to calculate the 1-

 The next table presents all the forward rates

 By rewriting the general forward rate formula it is

 If the zero curve is upward sloping, i.e. Ry>Rx,

 If the zero curve is downward sloping, i.e. Ry<Rx,

 In the above equation R is the zero rate for a

 And RF is referred to as the instantaneous forward

 Payments are calculated against a pre-agreed

 The interest rate RK applies to some principal L

 The next table illustrates the cash flows resulting

 The value of the agreement at time 0, V(0), can