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Document Date: November 2, 2006
 An Introduction To Derivatives And Risk Management 
, 7
th
EditionDon Chance and Robert BrooksTechnical Note: Interest Rates and Financial Derivatives, Ch. 3, p. 56
This technical note supports the material in the Basic Notation and Terminologysection of Chapter 3 Principles of Option Pricing. We review here the appropriatediscount rate, calculating the accrual period, and interpreting interest rate quotations.
 Appropriate Discount Rate
Financial derivatives valuation and management depend on the ability to estimatethe fair market price and current market value of derivatives. Most calculations involvein some way the estimation of the present value or future value of cash flows. Hence,there is a need to estimate the appropriate discount factor. The discount factor is aconstant when multiplied by a known future cash flow yields the present value (PV) of that cash flow. The discount factor is a number less than one but greater than zero(hence, the word discount). The discount factor (DF) can be used to compute the futurevalue (FV) of a current cash flow by dividing.
( )
DFPVFVDFFVPV
==
 Traditionally, discount factors are expressed in terms of annualized interest rates, whichwe describe in detail later. The important observation at this point is that the discountfactor is the number by which monetary value is transported through calendar time.Historically in the United States, there have been two sources for interest rate dataused to compute discount factors, the London interbank offer rate (LIBOR) and the rateon a benchmark United States treasury security (UST). Early in the history of financialderivatives, the United States treasury rates were used widely. Increasingly, the financialderivatives industry has migrated to using LIBOR for a wide variety of reasons. Thefollowing is a partial summary of reasons LIBOR is preferred:
•
USTs are presently exempt from state and local taxes. This tax exemption makesUSTs more attractive to investors in high tax brackets. This increased demand for USTs drives up their prices and hence, lowers the yield to maturity.
 
•
As we covered in chapter 1, there is an active repurchase agreement market for USTs, facilitating the financing needs of derivative market participants and providing securities for short sellers. The ability to use USTs in repurchaseagreements is an added bonus for investing in USTs, increasing the demand for USTs and thus lowering the yield to maturity. At times, due to the high demand by short sellers for a particular UST, the rate offered in the repo market is high, providing an additional bonus.
•
The cost of trading in USTs changes over time due to a variety of factors. Thischange in liquidity makes USTs more or less attractive. Liquidity changes can bedriven by:
o
Varying supply of USTs based on U. S. budget surpluses or deficits
o
Varying demand for UST, during highly turbulent global events there isflight to quality, meaning investors place a high demand on USTs, drivingtheir yield to maturity low.
o
Perceived changes in default risk of USTs. High levels of U. S. debtincrease the likelihood of future financial distress.
•
USTs offer some unique benefits to commercial banks, increasing the demand for USTs. For example, when banks own USTs they do not have to set aside capitalas a provision for default, something banks have to do with commercial loans.
•
Although a rather obscure corner of financial markets, USTs offer several benefitsto municipal finance needs. Municipalities, such as state and local governmentscan issue federally tax-exempt debt securities. These municipal securities havevery low interest rates, thus providing a cheap source of funding for municipalities. When UST interest rates fall, municipalities are permitted toengage in “advanced refunding” of existing debt by issuing new bonds, investingthe proceeds in USTs, and placing USTs in a bankruptcy-proof trust for old bonds. Although a rather complex series of transactions, the net effect is toincrease the demand for USTs and hence lower the USTs yield to maturity.
IDRM7e, © Don M. Chance and Robert-Brooks Futures Risk Premiums
2
 
Similar to the repo rate, LIBOR is a good proxy for the
marginal 
 
dealer’s
cost of funds. By marginal we mean the derivative dealer that makes the next transaction or thatis the price setter. LIBOR is also the short-term opportunity cost of capital for financialinstitutions. That is, when a financial institution needs to borrow additional money, theycan access the LIBOR market. The marginal dealer’s credit rating is usually assumed to be AA (one notch below the high quality rating of AAA), so default risk is a possibility.There is growing evidence that the entire debt market is moving to use some variation of LIBOR as a benchmark.Interest rate data is widely available. Presently, data sources include the FederalReserve’s site for U. S. Treasuries athttp://www.federalreserve.gov/RELEASES/H15/data.htm and for LIBOR, the British Bankers Association site athttp://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141&a=627.We now turn to detailing interest rate quotation conventions and the calculation of the accrual period. The accrual period is important because interest rates are often quotedon an annualized basis. How one computes the fraction of the year under considerationwill impact the quoted interest rate.
 Accrual Period 
Although various accrual calculations are presented in the book, we summarize allthe major methodologies here. We also adopt a more detailed notation to be able to cover a wide variety of accrual period calculations in one place.The accrual period is the fraction of the year upon which an interest payment or interest rate calculation is to be made. The accrual period can be expressed as:
 NTD NADAP
=
 where denotes the number of accrued days and denotes the number of totaldays in the year.
 NADNTD
IDRM7e, © Don M. Chance and Robert-Brooks Futures Risk Premiums
3There are numerous ways that debt securities require the calculation of thenumber of days between two dates. This day count is used to compute the number of days of accrued interest and the number of days in a coupon period. As we will see, the
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