This action might not be possible to undo. Are you sure you want to continue?

# Financial Engineering and Risk Management

**Interest rates and ﬁxed income instruments
**

Martin Haugh Garud Iyengar

Columbia University

Industrial Engineering and Operations Research

Simple and compound interest

Deﬁnition. An amount A invested for n periods at a simple interest rate of r

per period is worth A(1 + n · r) at maturity.

Deﬁnition. An amount A invested for n periods at a compound interest rate of

r per period is worth A(1 + r)

n

at maturity.

Interest rates are typically quoted on annual basis, even if the compounding

period is less than 1 year.

n compounding periods in each year

rate of interest r

A invested for m years yields A

_

1 +

r

n

_

m·n

We will assume that rates are always quoted on an annual basis.

Deﬁnition. Continuous compounding corresponds to the situation where the

length of the compounding period goes to zero. Therefore, an amount A invested

for m years is worth lim

n→∞

A(1 + r/n)

mn

= Ae

rm

at maturity.

2

Present value

Cash ﬂow c = (c

0

, c

1

, c

2

, . . . , c

N

)

c

k

≥ 0 ≡ cash inﬂow, and vice versa

Present Value (PV) assuming annual compounding and interest rate r

PV(c; r) = c

0

+

c

1

(1 + r)

+

c

2

(1 + r)

2

+ . . .

c

N

(1 + r)

N

=

N

k=0

c

k

(1 + r)

k

.

No-arbitrage argument: Suppose one can borrow and lend at rate r

Portfolio: buy cash ﬂow, and borrow

c

k

(1+r)

k

for k years, k = 1, . . . , N

Cash ﬂow in year k: c

k

−

c

k

(1+r)

k

(1 + r)

k

= 0 for k ≥ 1

No-arbitrage: Cash ﬂow in year 0 = −p + c

0

+

N

k=1

c

k

(1+r)

k

≤ 0

Lower bound on price p ≥ PV(c; r)

Reverse the portfolio holding: sell cash ﬂow and lend

c

k

(1+r)

k

for k ≥ 1

No-arbitrage: p ≤ PV(c; r)

3

Diﬀerent lending and borrowing rates

Can lend at rate r

L

and borrow rate at rate r

B

: r

L

≤ r

B

Portfolio: buy cash ﬂow, and borrow

c

k

(1+r

B

)

k

for k years, k = 1, . . . , N

Cash ﬂow in year k: c

k

−

c

k

(1+r

B

)

k

(1 + r

B

)

k

= 0 for k ≥ 1

No-arbitrage: Cash ﬂow in year 0 = −p + c

0

+

N

k=1

c

k

(1+r

B

)

k

≤ 0

Lower bound on price p ≥ PV(c; r

B

)

Portfolio: sell cash ﬂow, and lend

c

k

(1+r

L

)

k

for k years, k = 1, . . . , N

Cash ﬂow in year k: −c

k

+

c

k

(1+r

L

)

k

(1 + r

L

)

k

= 0 for k ≥ 1

No-arbitrage: Cash ﬂow in year 0 = p −c

0

−

N

k=1

c

k

(1+r

L

)

k

≤ 0

Upper bound on price p ≤ PV(c; r

L

)

Bounds on the price PV(c; r

B

) ≤ p ≤ PV(c; r

L

)

How is the price set?

4

Fixed income securities

Fixed income securities “guarantee” a ﬁxed cash ﬂow. Are these risk-free?

Default risk

Inﬂation risk

Perpetuity: c

k

= A for all k ≥ 1

p =

∞

k=1

A

(1 + r)

k

=

A

r

Annuity: c

k

= A for all k = 1, . . . , n

Annuity = Perpetuity −Perpetuity starting in year n + 1

Price p =

A

r

−

1

(1 + r)

n

·

A

r

=

A

r

_

1 −

1

(1 + r)

n

_

5

Bonds

Features of bonds

Face value F: usually 100 or 1000

Coupon rate α: pays c = αF/2 every six months

Maturity T: Date of the payment of the face value and the last coupon

Price P

Quality rating: Issuer cannot pay the coupons

Yield to maturity λ

P =

2T

k=1

c

(1 + λ/2)

k

+

F

(1 + λ/2)

2T

Yield to maturity: interest rate at which price = present value

Quality and yield: inverse relation

Why do we think in terms of yields?

One number: summarizes face value, coupon and maturity

Relates to quality

Relates to interest rate movements

6

Financial Engineering and Risk Management

Floating rate bonds and term structure of interest rates

Martin Haugh Garud Iyengar

Columbia University

Industrial Engineering and Operations Research

Floating rate bonds

Cash ﬂow of ﬂoating rate bond

realized interest rate at time k −1: r

k−1

coupon payment at time k: r

k−1

F

face value at time n: F

Price P of a ﬂoating rate bond?

Theorem. (Linear Pricing) Suppose there is no arbitrage. Suppose the price of

cash ﬂow c

A

is p

A

, and price of cash ﬂow c

B

is p

B

. Then the price of cash ﬂow

c

A

+c

B

is p

A

+ p

B

.

Let p

k

= Price of contract paying r

k−1

F at time k. Then

Price P of ﬂoating rate bond = Price of Principal F at time n +

n

k=1

p

k

=

F

(1 + r

0

)

n

+

n

k=1

p

k

2

Price of contract that pays r

k−1

F at time k

t = 0 t = k −1 t = k

Buy contract −p

k

r

k−1

F

Borrow α over [0, k−1] α −α(1 + r

0

)

k−1

Borrow α(1 + r

0

)

k−1

over [k−1, k] α(1 + r

0

)

k−1

−α(1 + r

k−1

)(1 + r

0

)

k−1

Lend α from [0, k] −α α(1 + r

0

)

k

Choose α so the cash ﬂow at time k is deterministic

c

k

= r

k−1

F −α(1 + r

0

)

k−1

(1 + r

k−1

) + α(1 + r

0

)

k

Therefore,

α = F(1 + r

0

)

−(k−1)

⇒ c

k

= α(1 + r

0

)

k−1

r

0

= Fr

0

⇒ p

k

=

Fr

0

(1 + r

0

)

k

Linear pricing theorem implies that

P =

F

(1 + r

0

)

n

+

n

k=1

p

k

= F.

3

Term structure of interest rates

Interest rates depends on the term or duration of the loan. Why?

Spot rates: s

t

= interest rate for maturity in t years

A in t year ⇒ PV =

A

(1 + s

t

)

t

Discount rate d(0, t) =

1

(1+s

t

)

t

Forward rate f

uv

: interest rate quoted today for lending from year u to v.

(1 + s

v

)

v

= (1 + s

u

)

u

(1 + f

uv

)

(v−u)

⇒ f

uv

=

_

(1 + s

v

)

v

(1 + s

u

)

u

_

1

v−u

−1

Relation between spot and forward rates

(1 + s

t

)

t

=

t−1

k=0

(1 + f

k,k+1

)

Can infer the spot rates from bond prices.

4