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Financial Mathematics Actuaries
Financial Mathematics Actuaries
for Actuaries
Chapter 3
Spot Rates, Forward Rates and
the Term Structure
Learning Objectives
1. Spot rate of interest
2. Forward rate of interest
3. Yield curve
4. Term structure of interest rates
Thus, we define iSt as the spot rate of interest, which is the annualized
eective rate of interest for the period from time 0 to t.
The subscript t in iSt highlights that the annual rate of interest varies
with the investment horizon.
Hence, a unit payment at time 0 accumulates to
a(t) = (1 + iSt )t
(3.1)
at time t.
The present value of a unit payment due at time t is
1
1
.
=
S t
a(t)
(1 + it )
(3.2)
time 2.
Alternatively, she can invest a unit payment at time 0 over 1 period,
and enters into a forward agreement to invest 1 + iS1 unit at time 1
to earn the forward rate of iF2 for 1 period.
This rollover strategy will accumulate to (1 + iS1 )(1 + iF2 ) at time 2.
The two strategies will accumulate to the same amount at time 2,
so that
(1 + iS2 )2 = (1 + iS1 )(1 + iF2 ),
(3.3)
if the capital market is perfectly competitive, so that no arbitrage
opportunities exist.
Equation (3.3) can be generalized to the following relationship con-
(3.4)
for t = 2, 3, .
We can also conclude that
(1 + iSt )t = (1 + iF1 )(1 + iF2 ) (1 + iFt ).
(3.5)
Given iSt , the forward rates of interest iFt satisfying equations (3.4)
and (3.5) are called the implicit forward rates.
The quoted forward rates in the market may dier from the implicit
forward rates in practice, as when the market is noncompetitive.
Unless otherwise stated we shall assume that equations (3.4) and
(3.5) hold, so that it is the implicit forward rates we are referring to
in our discussions.
7
(1 + iSt )t
=
1.
(1 + iSt1 )t1
(3.6)
Example 3.1: Suppose the spot rates of interest for investment horizons
of 1, 2, 3 and 4 years are, respectively, 4%, 4.5%, 4.5%, and 5%. Calculate
the forward rates of interest for t = 1, 2, 3 and 4.
Solution: First, iF1 = iS1 = 4%. The rest of the calculation, using (3.6),
is as follows
iF2
(1 + iS2 )2
(1.045)2
=
1=
1 = 5.0024%,
S
1 + i1
1.04
S 3
3
)
(1
+
i
(1.045)
3
1=
1 = 4.5%
iF3 =
S 2
2
(1 + i2 )
(1.045)
and
S 4
4
)
(1
+
i
(1.05)
4
1=
1 = 6.5144%.
iF4 =
S 3
3
(1 + i3 )
(1.045)
2
Example 3.2: Suppose the forward rates of interest for investments in
year 1, 2, 3 and 4 are, respectively, 4%, 4.8%, 4.8% and 5.2%. Calculate
the spot rates of interest for t = 1, 2, 3 and 4.
Solution: First, iS1 = iF1 = 4%. From (3.5) the rest of the calculation
is as follows
h
i1
2
S
F
F
i2 = (1 + i1 )(1 + i2 ) 1 = 1.04 1.048 1 = 4.3992%,
iS3
= (1 +
and
iF1 )(1
iS4
iF2 )(1
(1 +
i1
iF3 )
1
3
1 = (1.041.0481.048) 1 = 4.5327%
iF1 )(1
iF2 )(1
9
iF3 )(1
i1
iF4 )
1
4
and
(1 + iSt+ )t+ = (1 + iSt )t (1 + iFt, ) ,
10
for t 1, > 0.
(3.8)
Example 3.3:
Based on the spot rates of interest in Example 3.1,
calculate the multi-period forward rates of interest iF1,2 and iF1,3 .
Using (3.7) we obtain
Solution:
iF1,2
= [(1 +
iF2 )(1
F 12
i3 )]
1
2
Similarly, we have
1
"
(1 + iS3 )3
1 + iS1
#1
#1
"
(1.045)
1=
1.04
#1
1 = 4.7509%,
"
#1
1 = 5.3355%.
and similarly,
iF1,3
"
(1 + iS4 )4
1 + iS1
(1.05)
1=
1.04
11
12
Figure3.4:YieldcurvesoftheUSmarket
13
n
X
1
a(t)
1
=
S t
(1
+
i
t)
t=1
1
1
1
=
+
+
.
+
S
S 2
S
n
(1 + i1 ) (1 + i2 )
(1 + in )
t=1
n
X
14
(3.9)
(1 + iSt )t
t
Y
j=1
(3.11)
+
.
=
F
F
F
F
F
(1 + i1 ) (1 + i1 )(1 + i2 )
(1 + i1 ) (1 + in )
15
(3.13)
"n1
X
(1 + iFt,nt )nt + 1
t=1
n1
X
t=1
n
Y
(1 + iFj ) + 1
j=t+1
= [(1 + iF2 )(1 + iF3 ) (1 + iFn )] + [(1 + iF3 )(1 + iF4 ) (1 + iFn )] +
16
+ (1 + iFn ) + 1.
(3.14)
" n
Y
# "
(1 + iFt )
t=1
1
1
1
+ +
+
.
1 + iF1
(1 + iF1 )(1 + iF2 )
(1 + iF1 ) (1 + iFn )
(3.16)
Hence,
sne =
n
Y
t=1
(3.17)
" n
X
1
.
S t
t=1 (1 + it )
(3.18)
Example 3.4: Suppose the spot rates of interest for investment horizons
of 1, 2, 3 and 4 years are, respectively, 4%, 4.5%, 4.5%, and 5%. Calculate
a4e , s4e , a3e and s3e .
Solution:
1
1
1
1
+
+
= 3.5763.
a4e =
+
1.04 (1.045)2 (1.045)3 (1.05)4
From (3.17) we obtain
s4e = (1.05)4 3.5763 = 4.3470.
Similarly,
1
1
1
+
= 2.7536,
+
a3e =
2
3
1.04 (1.045)
(1.045)
and
s3e = (1.045)3 2.7536 = 3.1423.
18
2
Example 3.5:
Suppose the 1-period forward rates of interest for investments due at time 0, 1, 2 and 3 are, respectively, 4%, 4.8%, 4.8% and
5.2%. Calculate a4e and s4e .
Solution:
a4e
1
1
1
1
=
+
+
+
1.04 1.04 1.048 1.04 1.048 1.048 1.04 1.048 1.048 1.052
= 3.5867.
2
To further understand (3.17), we write (3.13) as (see (3.8))
(1 +
iFt,nt )nt
(1 + iSn )n
a(n)
=
=
.
S t
(1 + it )
a(t)
(3.19)
Thus, the future value of the annuity is, from (3.14) and (3.19),
sne =
"n1
X
(1 + iFt,nt )nt + 1
t=1
n
X
a(n)
=
t=1 a(t)
= a(n)
n
X
1
t=1
= a(n)ane .
20
a(t)
(3.20)
iSnt )nt
(1 + iSn )n
a(n)
6=
=
,
(1 + iSt )t
a(t)
1 (1.04)
1 (1.04)1
= $545.18.
100 a
6e0.04 = 100
The present value at time 0 for the deferred annuity-due in the last 4 years
22
is
"
10
1 (1.05)
1 (1.05)
1 (1.05)1
1 (1.05)1
= 100 (8.1078 5.3295)
6e0.05 ) = 100
100 (
a10e0.05 a
= $277.83.
Hence, the present value of the 10-period annuity-due is
545.18 + 277.83 = $823.01.
We now consider the future value of the annuity at time 10. Under assumption (a) that future payments earn the forward rates of interest, the
future value of the annuity at the end of year 10 is, by equation (3.20),
(1.05)10 823.01 = $1,340.60.
23
Note that using (3.20) we do not need to compute the forward rates of
interest to determine the future value of the annuity, as would be required
if (3.16) is used.
Based on assumption (b), the payments at time 0, , 4 earn interest at 5%
per year (the investment horizons are 10 to 6 years), while the payments
at time 5, , 9 earn interest at 4% per year (the investment horizons are
5 to 1 years). Thus, the future value of the annuity is
100 (
s10e0.05 s5e0.05 ) + 100 s5e0.04 = $1,303.78.
Thus, equation (3.20) does not hold under assumption (b).
24
25
so that
a(t)at ( ) = a(t + ),
(3.23)
a(t + )
at ( ) =
.
a(t)
(3.24)
so that
1
iFt, = [at ( )] 1.
(3.25)
If < 1, we define the forward rate of interest per unit time (year)
for the fraction of a period t to t + as
iFt,
1 at ( ) at (0)
at ( ) 1
=
=
.
at (0)
(3.26)
at ( ) 1
= lim
0
"
#
1
a(t + )
= lim
1
0
a(t)
"
#
a(t + ) a(t)
1
=
lim
a(t) 0
27
a0 (t)
=
a(t)
= (t).
(3.27)
1
2
= (1.2581) 1 = 12.16%
and
iF2,2.5
= (1.3327)
1
2.5
1 = 12.17%.
Thus, the forward rates exceed the spot rates, which agrees with what
might be expected of an upward sloping yield curve.
2
29
We can further establish the relationship between the force of interest and the forward accumulation function, and thus the forward
rates of interest.
From (3.24), we have
R
t+
Z t+
exp 0 (s) ds
a(t + )
R
= exp
at ( ) =
(s) ds ,
=
t
a(t)
t
exp 0 (s) ds
(3.28)
so that we can compute the forward accumulation function from the
force of interest.
Solution:
a2 (t) = exp
= exp(0.025t2 +0.1t).
1
2
= (1.3499) 1 = 16.18%.
2
tj t
Cj atj (t tj ) +
tj >t
Cj
"
1
at (tj t)
Cj
tj t
n
X
Cj
j=1
= a(t)
"
"
n
X
a(t)
+
a(tj )
t
a(t)
a(tj )
j >t
Cj
"
a(t)
a(tj )
Cj v(tj )
j=1
32
C(t)at ( t) dt +
Z n
C(t)
dt =
a (t )
Z
C(t)a( )
dt +
a(t)
0
Z n
C(t)
dt
= a( )
0 a(t)
= a( )
Z n
Z n
C(t)a( )
C(t)v(t) dt.
a(t)
(3.30)
33
dt
Solution:
We first compute the present value of the annuity. The
payments of $2 are due at time 2, 3, 4 and 5. Thus, the present value of
the cash flows is
2
"
1
1
1
1
.
+
+
+
a(2) a(3) a(4) a(5)
1
1
1
1
2
= 2 2.82866 = $5.6573,
+
+
+
1.18 1.33 1.52 1.75
and the value of the cash flow at time 3 is a(3) 5.6573 = 1.33 5.6573 =
$7.5242.
2
Example 3.10:
Suppose (t) = 0.02t. An investor invests in a fund
at the rate of 10t per period at time t, for t > 0. How much would she
34
accumulate in the fund at time 2? You may assume that future payments
earn the forward rates of interest.
Solution:
The amount she invests in the period (t, t + t) is 10tt,
which would accumulate to (10tt)at (2 t) at time 2. Thus, the total
amount accumulated at time 2 is
Z 2
0
10tat (2 t)dt.
Z 2
(s) ds = exp
Z 2
0.02s ds .
Now, we have
Z 2
t
so that
at (2 t) = exp(0.04 0.01t2 )
and
Z 2
0
10tat (2 t)dt = 10
Z 2
te0.040.01t dt
= 10e0.04
Z 2
te0.01t dt
10e0.04 0.01t2 2
e
]0
=
0.02
10e0.04 (1 e0.04 )
=
0.02
= 20.4054.
2
Example 3.11:
force of interest (t), for t > 0. What is the present value of the interest
earned over n periods.
Solution:
As (t) is the instantaneous rate of interest per period at
time t, the amount of interest earned in the period (t, t + t) is C(t)t,
and the present value of this interest is [C(t)t]v(t). Thus, the present
value of all the interest earned in the period (0, n) is
Z n
C(t)v(t) dt.
Now, we have
Z n
(t)v(t) dt =
Z n
0
(t) exp
exp
= exp
Z 0
0
Z t
0
Z t
(s) ds dt
(s) ds
(s) ds exp
37
Z n
0
(s) ds
= 1 v(n).
Hence, the present value of the interest earned is
C[1 v(n)] = C Cv(n),
which is the principal minus the present value of the principal redeemed
at time n.
2
38