Chapter 4

Interest Rates

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Types of Rates
Treasury rates
Overnight rates
Repo rates
LIBOR

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Treasury Rate
Rate on instrument issued by a government
in its own currency

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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

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Repo Rate
Repurchase agreement is an agreement
where a financial institution that owns
securities agrees to sell them for X and buy
them bank 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
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LIBOR
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?

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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
https://www.forbes.com/advisor/investing/what-is-libor/#:~:text=Effective
%20December%2031%2C%202021%2C%20Libor,and%20more%20se
cure%20pricing%20benchmark
.
https://www.investopedia.com/articles/investing/112014/who-uses-libor-
data-and-why.asp#:~:text=LIBOR%20has%20been%20subject%20to,it
s%20use%20beginning%20after%202021
.
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The New Reference Rates
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)
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The New Reference Rates
SOFR is calculated from repos and is
therefore a secured rate
The others are calculated from unsecured
overnight borrowing and lending between
banks

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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 US
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
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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
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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

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Continuous Compounding (equation 4.2)
In the limit as we compound more and more
frequently we obtain continuously compounded
interest rates.
Formula: AeRn where, A= amount invested,
R=compounded interest rate, n= number of years
$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
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Conversion Formulas (Equations 4.4 and
4.4)

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 
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Examples
10% with semiannual compounding is
equivalent to 2ln(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
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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)

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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
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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%.
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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
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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
(100  100 d ) m
c
A
(in our example, m = 2, d = 0.87284, and A =
3.70027)
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Data to Determine Zero Curve
(Table 4.3)

Bond Time to Coupon per Bond price

Principal Maturity year ($)* ($)
(yrs)
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 each year

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The Bootstrap Method
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

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The Bootstrap Method continued
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%

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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

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Forward Rates
The forward rate is the future zero rate
implied by today’s term structure of interest
rates

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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
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Application of the Formula (Table
4.5)

Year (n) Zero rate for n- Forward rate for

year investment nth year
(% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5

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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

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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

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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

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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

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Duration (equation 4.8)
Duration of a bond that provides cash flow ci
at time ti is
 ci e  yti 
n
D  ti  
i 1  B 

where B is its price and y is its yield

(continuously compounded)

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Key Duration Relationship
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

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Key Duration Relationship 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”

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