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    Interest Rates: Options, Futures, and Other Derivatives 6

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    Interest Rates: Options, Futures, and Other Derivatives 6

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    Interest Rates: Options, Futures, and Other Derivatives 6

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    Hay Jirenyaa

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    © All Rights Reserved
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    of 30

    Interest Rates

    Chapter 4

    Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005 4.1
    Types of Rates
    For any given currency, many different
    types of interest rates are regularly
    quoted (mortgage rates, deposit rates,
    prime rates...)
    Treasury rates

    LIBOR rates

    Repo rates

    Options, Futures, and Other Derivatives 6th Edition, 4.2


    Types of Rates
    Treasury rates are treated as risk-free rates
    Derivatives traders do not usually use Treasury rates as risk-free
    rates. Instead they use LIBOR rates.
    LIBOR rates: 1 mo, 3 mo, 6 mo, 12 mo. in all
    major currencies.
    Bank must have AA credit rating in order to operate in LIBOR
    market
    LIBOR is not totally risk-free
    In this book LIBOR will be interpreted as risk-free
    LIBOR and LIBID trade in what is known Eurocurrency market
    Repo rates, also with very little credit risk.
    Most common is the overnight REPO
    Term (long term) REPOs also exist.

    Options, Futures, and Other Derivatives 6th Edition, 4.3


    Measuring Interest Rates

    The compounding frequency used


    for an interest rate is the unit of
    measurement
    The difference between quarterly
    and annual compounding is
    analogous to the difference
    between miles and kilometers

    Options, Futures, and Other Derivatives 6th Edition, 4.4


    Effect of the compounding frequency
    on the value of $100 at the end of 1
    year when thefrequency
    Compounding interest rate is 10%
    Value of p.a.
    $100 at
    the end of year
    Annually (m = 1) 110.00
    Semiannually (m = 2) 110.25
    Quarterly (m = 4) 110.38
    Monthly (m = 12) 110.47
    Weekly (m = 52) 110.51
    Daily (m = 365) 110.52

    Options, Futures, and Other Derivatives 6th Edition, 4.5


    Generalization: Terminal value of
    the investment is:

    A 1 R
    T

    mT
    R
    A 1
    m
    A amount, T no. of years, R interest
    rate, m compounded frequency per year

    Options, Futures, and Other Derivatives 6th Edition, 4.6


    Continuous Compounding
    (Page 79)

    In the limit as we compound more and more


    frequently we obtain continuously compounded
    interest rates
    $100 grows to $100eRT when invested at a
    continuously compounded rate R for time T
    $100 received at time T discounts to $100e-RT at
    time zero when the continuously compounded
    discount rate is R

    Options, Futures, and Other Derivatives 6th Edition, 4.7


    Conversion Formulas
    (Page 79)

    Define
    Rc : continuously compounded rate
    Rm: same rate with compounding m times
    per year
    Rm
    Rc m ln 1
    m


    Rm m e Rc / m 1
    Options, Futures, and Other Derivatives 6th Edition, 4.8
    Zero Rates or Spot 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

    Options, Futures, and Other Derivatives 6th Edition, 4.9


    Example (Table 4.2, page 81)

    Maturity Zero Rate


    (years) (% cont comp)
    0.5 5.0
    1.0 5.8
    1.5 6.4
    2.0 6.8

    Options, Futures, and Other Derivatives 6th Edition, 4.10


    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

    0.05 0.5 0.058 1.0 0.064 1.5


    3e 3e 3e
    103e 0.068 2.0 98.39
    Options, Futures, and Other Derivatives 6th Edition, 4.11
    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
    Suppose that the market price of the bond in
    our example equals its theoretical price of
    98.39
    The bond yield (continuously compounded) is
    given by solving
    y 0.5 y 1.0 y 1.5 y 2 .0
    3e 3e
    to get y=0.0676 or 6.76%. 3e 103e 98.39

    Options, Futures, and Other Derivatives 6th Edition, 4.12


    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

    c 0.050.5 c 0.0581.0 c 0.0641.5


    e e e
    2 2 2
    c 0.0682.0
    100 e 100
    2
    to get c=6.87 (with s.a. compoundin g)

    Options, Futures, and Other Derivatives 6th Edition, 4.13


    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 of the bond and
    A is the present value of an annuity of $1
    on each coupon date

    (100 100d )m
    c
    A

    Options, Futures, and Other Derivatives 6th Edition, 4.14


    Sample Data (Table 4.3, page 82)
    Bond Time to Annual Bond Cash
    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

    Options, Futures, and Other Derivatives 6th Edition, 4.15


    The Bootstrap Method

    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
    Similarly the 6 month and 1 year rates are
    10.469% and 10.536% with continuous
    compounding

    Options, Futures, and Other Derivatives 6th Edition, 4.16


    The Bootstrap Method continued

    To calculate the 1.5 year rate we solve


    0.104690.5 0.105361.0 R1.5
    4e 4e 104e 96

    to get R = 0.10681 or 10.681%

    Similarly the two-year rate is 10.808%

    Options, Futures, and Other Derivatives 6th Edition, 4.17


    Zero Curve Calculated from the
    Data (Figure 4.1, page 84)
    12
    Zero
    Rate (%)
    11

    10.68 10.808
    10.469 10.53 1
    10 6
    10.127

    Maturity (yrs)
    9
    0 0.5 1 1.5 2 2.5

    Options, Futures, and Other Derivatives 6th Edition, 4.18


    Forward Rates

    The forward rate is the future zero rate


    implied by todays term structure of interest
    rates

    Options, Futures, and Other Derivatives 6th Edition, 4.19


    Calculation of Forward Rates
    Table 4.5, page 85

    Zero Rate for Forward Rate


    an n -year Investment for n th Year
    Year (n ) (% per annum) (% per annum)

    1 3.0
    2 4.0 5.0
    3 4.6 5.8
    4 5.0 6.2
    5 5.3 6.5

    Options, Futures, and Other Derivatives 6th Edition, 4.20


    Formula for Forward Rates

    Suppose that the zero rates for time


    periods T1 and T2 are R1 and R2 with both
    rates continuously compounded.
    The forward rate for the period between
    times T1 and T2 is
    R2T2 R1T1
    RF
    T2 T1

    Options, Futures, and Other Derivatives 6th Edition, 4.21


    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
    R
    RF R T
    T
    where R is the T-year rate

    Options, Futures, and Other Derivatives 6th Edition, 4.22


    Upward vs Downward Sloping
    Yield Curve

    Foran upward sloping yield curve:


    Fwd Rate > Zero Rate > Par Yield

    For a downward sloping yield curve


    Par Yield > Zero Rate > Fwd Rate

    Options, Futures, and Other Derivatives 6th Edition, 4.23


    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

    Options, Futures, and Other Derivatives 6th Edition, 4.24


    Forward Rate Agreement
    continued
    An FRA is equivalent to an agreement
    where interest at a predetermined rate, RK
    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

    Options, Futures, and Other Derivatives 6th Edition, 4.25


    Valuation Formulas (equations 4.9 and 4.10
    page 88)

    Value of FRA where a fixed rate RK will be


    received on a principal L between times T1 and T2
    R T
    is L ( RK R F )(T2 T1 ) e 2 2

    Value of FRA where a fixed rate is paid is


    L( RF RK )(T2 T1 )e R2T2
    RF is the forward rate for the period and R2 is the
    zero rate for maturity T2
    What compounding frequencies are used in
    these formulas for RK, RM, and R2?
    Options, Futures, and Other Derivatives 6th Edition, 4.26
    Duration (page 89)

    Duration of a bond that provides cash flow c i at time t i is


    n
    ci e yti
    ti
    B

    i 1
    where B is its price and y is its yield (continuously
    compounded)
    This leads to
    B
    Dy
    B
    Options, Futures, and Other Derivatives 6th Edition, 4.27
    Duration Continued
    When the yield y is expressed with
    compounding m times per year
    BDy
    B
    1 y m
    The expression
    D
    1 y m

    is referred to as the modified duration


    Options, Futures, and Other Derivatives 6th Edition, 4.28
    Convexity

    The convexity of a bond is defined as


    n

    1 B 2 i ie
    c t 2 yti

    C i 1
    B y 2
    B
    so that
    B 1
    Dy C (y ) 2
    B 2
    Options, Futures, and Other Derivatives 6th Edition, 4.29
    Theories of the Term Structure
    Page 93

    Expectations Theory: forward rates equal expected


    future zero rates
    Market Segmentation: short, medium and long rates

    determined independently of each other


    Liquidity Preference Theory: forward rates higher than

    expected future zero rates

    Options, Futures, and Other Derivatives 6th Edition, 4.30

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