Options, Futures, and Other Derivatives

Thirteenth Edition

Chapter 4
Interest Rates
Types of Rates
• Treasury rates
• Overnight rates
• Repo rates
• LI BO R
Treasury Rate
• Rate on instrument issued by a government in its own
currency
Overnight Rates
• Unsecured borrowing and lending between banks as they
adjust the reserve requirements they are required to keep
with the central bank.
• Referred to as the Fed Funds Rate in the U.S.
• The effective fed funds rate is the weighted average of
the rates on brokered transactions.
• Central bank may intervene with its own transactions to
raise or lower the overnight rate.
Repo Rate
• Repurchase agreement is an agreement where a
financial institution that owns securities agrees to sell
them for X and buy them back in the future (usually the
next day) for a slightly higher price, Y
• The financial institution obtains a loan.
• The rate of interest is calculated from the difference
between X and Y and is known as the repo rate.
LIB OR
• LIBOR is the rate of interest at which a AA-rated bank
estimates it can borrow money on an unsecured basis
from another bank at 11am.
• Several currencies and maturities
• There have been some suggestions that banks
manipulated LIBOR during certain periods. Why would
they do this?
LIBOR Phase Out
• Regulators plan to phase out LIBOR by the end of 2021
and replace it with rates based on transactions observed
in the overnight market.
• The new reference rates (e.g., for a 3-month period) will
be calculated at the end of the period as the compounded
overnight rates for that period.
The New Reference Rates (1 of 2)
• US dollar: SOFR (secured overnight funding rate)
• GBP: SONIA (sterling overnight index average)
• EU: ESTER (euro short-term rate)
• Switzerland: SARON (Swiss average overnight rate)
• Japan: TONAR (Tokyo average overnight rate)
The New Reference Rates (2 of 2)
• SOFR is calculated from repos and is therefore a
secured rate.
• The others are calculated from unsecured overnight
borrowing and lending between banks.
The Risk-Free Rate
• The Treasury rate is considered to be artificially low
because:
– Banks are not required to keep capital for Treasury
instruments.
– Treasury instruments are given favorable tax treatment
in the U. S.
.

• The new reference rates are considered to be proxies for

the risk-free rate.
• Other “risky” reference rates incorporating a credit spread
may be developed.
Impact of Compounding (Table 4.1)
When we compound m times per year at rate R, an
amount A grows to A(1  R /m )m in one year.

Compounding frequency Value of $100 in one year at 10%

Annual (m = 1) 110.00
Semiannual (m = 2) 110.25
Quarterly (m = 4) 110.38
Monthly (m = 12) 110.47
Weekly (m = 52) 110.51
Daily (m = 365) 110.52
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 kilometres.
Continuous Compounding (Equation 4.2)
• 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
Conversion Formulas (Equations 4.3 and 4.4)
Define
Rc : continuously compounded rate
Rm : same rate with compounding m times per year

 R 
Rc  m ln  1  m 
 m 
 
Rm  m e Rc / m  1
Examples
• 10% with semiannual compounding is equivalent to
2 ln(1.05)  9.758% with continuous compounding

• 8% with continuous compounding is equivalent to

4(e0.08/4  1)  8.08% with quarterly compounding

• Rates used in option pricing are nearly always

expressed with continuous compounding.
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 4.2)

Maturity (years) Zero rate (% cont. comp.)

0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
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:

3e 0.050.5  3e 0.0581.0  3e 0.0641.5

 103e 0.0682.0  98.39
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%.

Par Yield (1 of 2)
• 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
  100   e 0.0682.0  100
 2
to get c = 6.87
Par Yield (2 of 2)
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,

(100  100d )m
c
A

(in our example, m = 2, d = 0.87284, and A = 3.70027)

Data to Determine Zero Curve (Table 4.3)

Bond Principal Time to Coupon Bond price ($)

Maturity (yrs) per year ($) *

100 0.25 0 99.6

100 0.50 0 99.0
100 1.00 0 97.8
100 1.50 4 102.5
100 2.00 5 105.0

* Half the stated coupon is paid every six months

The Bootstrap Method (1 of 2)
• An amount 0.4 can be earned on 99.6 during 3 months.
• Because 100  99.4e0.01603  0.25 the 3-month
rate is 1.603% with continuous compounding

• Similarly, the 6-month and 1-year rates are 2.010% and

2.225% with continuous compounding
The Bootstrap Method (2 of 2)
• To calculate the 1.5 year rate, we solve

2e 0.020100.5  2e 0.022251.0  102e  R1.5  102.5

to get R = 0.02284 or 2.284%

• Similarly, the two-year rate is 2.416%.

Zero Curve Calculated from the Data
(Figure 4.1)

3.00% Zero Rate

(% per annum)
2.50%

2.00%

1.50%

1.00%

0.50%
Maturity (years)
0.00%
0 0.5 1 1.5 2 2.5 3
Forward Rates
• The forward rate is the future zero rate implied by today’s
term structure of interest rates.
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

• This formula is only approximately true when rates

are not expressed with continuous compounding.
Application of the Formula (Table 4.5)

Year (n) Zero rate for n-year Forward rate for nth
investment year
(% per annum) (% per annum)
Blank

1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5
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.

Upward v s Downward Sloping
ersu

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 OTC agreement
that the actual rate applicable to a certain period will
be exchanged for a predetermined rate,
RK , with both being applied to a predetermined principal.
Forward Rate Agreement: Key Results
• An FRA can be valued by assuming that the forward
interest rate, RF , is certain to be realized.
• This means that the value of an FRA is the present
value of the difference between the interest that would
be paid at interest at rate RF and the interest that would
be paid at rate RK
Example
• An FRA entered into some time ago states that a
company will receive 5.8% (s.a.) and pay SOFR on
a principal of $100 million starting in 1.5 years.
• Forward SOFR for the period between 1.5 and 2
years is 5% (s.a.)
• The 2 year (SOFR) risk-free rate is 4% with
continuous compounding.
• The value of the FRA (in $ millions) is

100  (0.058  0.050 )  0.5  e 0.04  2  0.3692

Duration (Equation 4.8)
• Duration of a bond that provides cash flow ci

at time t i is

n  ci e  yti 
D   ti  
i 1  B 

where B is its price and y is its yield (continuously

compounded).
Key Duration Relationship (1 of 2)
• Duration is important because it leads to the following key
relationship between the change in the yield on the bond
and the change in its price:

B
 Dy
B
Key Duration Relationship (2 of 2)
• 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.”

Bond Portfolios
• The duration for a bond portfolio is the weighted average
duration of the bonds in the portfolio with weights
proportional to prices.
• The key duration relationship for a bond portfolio describes
the effect of small parallel shifts in the yield curve.
• What exposures remain if duration of a portfolio of assets
equals the duration of a portfolio of liabilities?
Convexity (Equation 4.14)
The convexity, C, of a bond is defined as

1 d 2B  i 1 ci t i2e  yti
n
C 2

B dy B

This leads to a more accurate relationship

B 1
 Dy  C  y 
2

B 2
When used for bond portfolios, it allows larger shifts in the
yield curve to be considered, but the shifts still have to be
parallel.
Theories of the Term Structure
• 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
Liquidity Preference Theory
(Table 4.7)

• Suppose that the outlook for rates is flat and you have
been offered the following choices:

Maturity (yrs) Deposit rate Mortgage rate

1 year 3% 6%
5 year 3% 6%

• Which would you choose as a depositor? Which for your

mortgage?
Liquidity Preference Theory
(Table 4.8)

• 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 (yrs) Deposit rate Mortgage rate

1 year 3% 6%

5 year 4% 7%
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