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.
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