Interest Rates

Chapter 4

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 1
Types of Rates

Treasury rates
LIBOR rates
Repo rates

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 2
 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

7th Edition, Copyright © John C. Hull
2008 3
Continuous Compounding
(Page 77)
 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

7th Edition, Copyright © John C. Hull
2008 4
Conversion Formulas
(Page 77)

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

7th Edition, Copyright © John C. Hull
2008 5
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

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 6
Example (Table 4.2, page 79)
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

7th Edition, Copyright © John C. Hull
2008 7
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

7th Edition, Copyright © John C. Hull
2008 8
 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
3e  y  0.5  3e  y 1.0  3e  y 1.5  103e  y  2.0  98.39
to get y=0.0676 or 6.76%.
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 9
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 0.050.5 c 0.0581.0 c 0.0641.5

e  e  e
2 2 2
 c  0.0682.0
 100  e  100
 2
to get c=6.87 (with s.a. compoundin g)
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 10
Par Yield continued
In general if m is the number of coupon
payments per year, P is the present value
of $1 received at maturity and A is the
present value of an annuity of $1 on each
coupon date
(100  100 P ) m
c
A

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 11
Sample Data (Table 4.3, page 80)
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

7th Edition, Copyright © John C. Hull
2008 12
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

7th Edition, Copyright © John C. Hull
2008 13
The Bootstrap Method continued
To calculate the 1.5 year rate we solve
0.104690.5 0.105361.0  R1.5
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

7th Edition, Copyright © John C. Hull
2008 14
 Zero Curve Calculated from the
Data (Figure 4.1, page 82)
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

7th Edition, Copyright © John C. Hull
2008 15
Forward Rates

The forward rate is the future zero rate

implied by today’s term structure of
interest rates

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 16
Calculation of Forward Rates
Table 4.5, page 83

n-year Forward Rate

zero rate 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

7th Edition, Copyright © John C. Hull
2008 17
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

R2 T2  R1 T1
T2  T1

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 18
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
RT
T
where R is the T-year rate

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 19
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

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 20
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

7th Edition, Copyright © John C. Hull
2008 21
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

7th Edition, Copyright © John C. Hull
2008 22
Valuation Formulas (equations 4.9 and
4.10, pages 86-87)
Value of FRA where a fixed rate RK will be
received on a principal L between times T1
and T2 is L(RK−RF)(T2−T1)exp(-R2T2)
Value of FRA where a fixed rate is paid is

L(RF−RK)(T2−T1)exp(-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, RF, and R2?
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 23
Duration (page 87-88)
 Duration of a bond that provides cash flow ci at
time ti is
n
 ci e  yti 
D   ti  
where B is itsi price
1 andBy is its yield
(continuously compounded)
 This leads to

B
  Dy
B
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 24
Duration Continued
When the yield y is expressed with
compounding m times per year
BDy
B  
1 y m
The expression
D
1 y m
is referred to as the “modified duration”

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 25
Convexity
The convexity of a bond is defined as
n

1 B
2 c t i i
2
e  yti

C  i 1

B y 2 B
so that
B 1
  Dy  C (y ) 2
B 2

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 26
Theories of the Term Structure
Page 91-92

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

7th Edition, Copyright © John C. Hull
2008 27
Liquidity Preference Theory
Suppose that the outlook for rates is flat
and you have been offered the following
choices
Maturity Deposit rate Mortgage rate
1 year 3% 6%
5 year 3% 6%

Which would you choose as a depositor?

Which for your mortgage?

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 28
Liquidity Preference Theory cont
To match the maturities of borrowers and
lenders a bank has to increase long rates
above expected future short rates
In our example the bank might offer

Maturity Deposit rate Mortgage rate

1 year 3% 6%

5 year 4% 7%

Options, Futures, and Other Derivatives

7th Edition, Copyright © John C. Hull
2008 29