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    Hull CH 4 - Interest Rates PDF

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    of 27
    fle rae Interest Rates 4a a Ioterest rates area factor inthe valuation of virtually al derivatives and will feature prominently in mach ofthe material that will be presented in theres of this book. This ‘Chapter deals with some fandamentalisues concerned with the way interest rates are fmeasured and analyzed, It explains the compounding fequency used to define an inter te and the mesning of continuously compounded interest rates, which are ‘sed extensively inthe anaes of derivatives It covers ero rates, par yields and yield turves dlacusts bond pricing, and outlines a “bootsiap” procedure commonly used by 1 dorvtives trading desk to ealealate zero-coupon Treasury interest aes, I also covers forward rues and forward rac agreements and reviews diferent theories of the term strate of interest rats, Finally, explains the use of uation and convexity measures to detrmine the sensitivity of bond prices to interest ate changes, ‘Chepte 6 wil cover interest rate futures and show how the daration measure can be ted when interest mte exposures aze hedged. For ease of exposition, day count ‘conventions wil be ignore throughout this chapter. The nature of thee conventions fod ter impact on calculations wil be dscused in Chapters 6 and 7 ‘TYPES OF RATES ‘An inert te in a particular situation defines the amount of money a borrower promis to pay the Inder. For any given currency, many different types of interest rates te replarly quoted. These inclide mortgage mates, deposit res, prime borrowing fates, ind 20 on. The interest rate applicable in a situation depends on the crit risk. ‘This ste ie that ther il be default by the borrower of funds, so tht the interest tnd pancipel are not paid to the lender as promised. The higher the credit risk, the Bighr the interes rate that is promised by the borrower. Treasury Rates “Treasury rates are the rates an investor ears on Treasury bills and Treasury bonds. ‘These are the instruments wsed by a government to borrow in its own currency. Jepansne Treasury rates ao the rates at which the Jpanese government borrows ia yeu; US Treasury ses ae the rates at which the US government borrows in US olan and wo on. Tt is usally ssrumed that thre is no chance that a goverment will 18 CHAPTER + 10.536 +05 x 10.681 = 10:6085% in four example.) Its aso usally assumed that the zero curve is horizoatal prior to the first point and horizontal beyond the ast point. Figure 4.1 shows the zero curve for our i, then Re > Ry (Le, the forvard ate fora period of time ending at 7; i grater thna the 1 mew rate) Silay, if the zero curve is downward sloping with Ry = Ry, then p< (icy the forward rate is ss than the T2210 rte) Taking limits 7; ‘approaches T; in equation (46) and letting the common value of the two be 7, we obtain ec rerik R= RTE Where 2 isthe zero rate fore maturity of T. The value of Ry obtained in this way is Known asthe instantaneous forvard rate fora maturity of 7. Ths is the forward fae ‘that is epplicable toa very sort future ie period that begin tte 7. Define PO, 7) Table 4.5 Calculation of forward LIBOR rates, Zero rate for an Forward rate year este for nth year Year (x) (G6 per annum) @é'per cman) 7 30 2 40 so 3 46 58 4 50 62 5 53 65 47 CHAPTER + 7 te 8 the prie ofa zerecoupon bond maturing at time 7. Because P(0, 7). ‘equation forthe instantaneous forward mite can alo be writen 38 Re a —Zinpo.7) By borrowing and nding at LIBOR, a large nancial netttion can lock in LIBOR orward rates. uppote LIBOR zero rates ae asi Table 4.5, It can borrow $100 at 3% {or 1 year and inves! the money at 4% for 2 year, the rel isa cash outflow of 00»! $103.05 athe end of year | and an inflow of 100d? = $108.33 at te end of year 2 Sine 108.33 = 10305e%5, a return equal to the forward rate (5%) is ‘armed on $103.05 during the second year. Alternatively, it ean borrow $100 forfour year at $% and invest it for three years at 46%. The result i a cash inflow of 100s} =$11480 at the end of the third year and 2 cath ouilow of 100en¢ = $122.14 tthe end ofthe fourth year. Sine 122.16= 114.806, money is being borrowed forthe fourth year tthe forward rate of 6 2%. Ia large investor thinks that rates in the future wil be diferent from today’s forward tates there are many tading strategies thatthe investor wil ind attractive (se Busines, ‘Snapshot 42). One ofthese involves entering into a contract known as a formard rte ‘agreement. We will new discuss how this contract works and how its valed FORWARD RATE AGREEMENTS ‘A forward rate agreement (FRA) i an over-the-counter agreement designed to ensue that a certain interest ate wil apply to either borrowing or lending «certain principal during specified tue period of ime. The assumption underlying the contac s tht {he borrowing or lendng would normally be dove at LIBOR. (Consider a forward mate agreement where company X is agrecng told money to company ¥ for the prod of time between 7; and 7 Define: 2g: The mite of interest agreed to in the FRA, Ry: The forward LIBOR interest rate forthe period betwoen times 7; and 7, caleulated today! ‘Ry: The actual LIBOR interest rte observed in the market at time 7, for the period betworn times 7; and 7; 1L: The principal underiyng the contrat. ‘We will depart from ur usual assumption of continuous compounding and assume that the rates Ry, Hy, and Ry are all measured with a compounding frequency refeeding the length of the period to which they apply. This means that if T,~T,=05, they ar expressed with semiannual compounding, if 7,7, =025, they are expressed wit quarterly compounding, and so on. (This assumption corres: ‘ponds to the urual market practice for FRAB). ‘Normally company X would aro Ry from the LIBOR loan, The FRA means that it vill earn Ry. The extra interest ate (which may be negative that tears as arm of “IWR evar rnd ot did I Seton 46 en he LIDOR/we ro cane, Te later tote the wy re is Seon 7 Interest Rates a Business Snapshot 4.2 Orange County's Yield Curve Plays ‘Suppose a large investor cun borow or lend atthe rie given in Table 45 and thinks ‘hat I-yer interes rte will ot change much over the not 3 yours. The investor can borrow I-year funds and invest for Syers. The -yeurborsowings can be rolled oer for further year periods atthe end ofthe fit, cond, third, and fourth years. I intrest rates do stay about the same, this strategy wll yield a profit of about 23% er yer, because imtreat will be recived at $3% and paid at 3%, This type of trading sty Is known asa yield curve la. The nestor i specatng that tex ‘the futur wl be ult dierent fom the forward rte observed inthe market today our example, forward rate observed in the marit today for future I-yea prio | a $%, 58%, 62%, and 6.3%) Robert Citron, the Treasurer at Orange County, sed yield curve plays similar to the one we have just described very succesfully it 1992 and 1983, The profit from Mr. Cluoa's tades became an important contrtutor to Orange County's budget tnd he was reece. (No one listened to his opponent in the election wh said his Uuadingsraagy wes 10 risky) In 1994 Mr. Citron expanded his yield curve plays. He invested heavily in inverse airs. These pay arate of interest equi 0 «fol rae of intro minut a floating ‘ate. He alo leveraged his position by borrowing the repo markt. I short teem interest rates had remained the same or delned he would have continued to dowel, ‘As it happened, interest rates cone sbrply during 1994. On December 1, 1994, Orange County announced that Ks investment portfolio had lost $1.5 bilion and several dye later led for bankruptcy protection. entering into the FRA is Ry ~ Ry. The interes rei stat tie 7 and paid a ine 7, ‘The ext interest rate therefore leads toa cah flow to company X at time 7; of| URe~ RuXTe~T) an ‘Similarly ther is cash fw to company ¥ at tine T; of Ly ~ Re, —T) as From equations (4.7) and (48), we see that ther is snother interpretation of the FRA. Itisan agreement where company X wil recite ateret onthe principal between 1 and Ty atthe fxd rte of Ry aod pay interes the realized LIBOR tate of hy. ‘Company ¥ will pay interest onthe principal between T; and Tat the ned rte of Ric and recive interest at Ry. Usually FRAS are setded at tine 7; miber then 7, The pay must then be @scounted from time 7; to 7}. For company X, the payof at time 7, Ug ~ RuXt,=T) T+ Rul =T) and, for company Y, the payolT at time 7 UB ~ ReX = T) T+ ylG,=T) CHAPTER + Example 4.3 Suppose that a company enters into an FRA that i designed to ensure it wil recrve a flked rats of 4% on a principal of $100 millon for» $month period staring in 3 years, The FRA is an exchange where LIBOR ts piid and 4% 8 ‘revived forthe 3month pecod. If }anonth LIBOR proves to te 4.5% forthe month period the cashflow tothe lender willbe 100,00,060 x (0.04 ~ 0.45) x 0.2 $125,000 the 325-year point. This i equivalent toa cash fw of 25000 Toes 025 st the 3.ear pont. The cash flow to the party on the oppose side of the transaction will be +$125,000 atthe 3.25 year point or +$123605 atthe 3-year Pia (All inter ates quoted in thie ample re expresed vith quaely compounding) Valuation, ‘To valu an FRA we fist note that itis always worth zero when Rx = Ry? This it boss, a8 noted in Setion 46,» large ancl naittion ean t no cet lock in the forward rate fora future tie period. Por example, ican ensure thai care the forward rate forthe tne period between years 2 and 3 by borrowing eta emount of money fr 2 years and invetng i for 3 years Silay ican ensue hat it pays the forward rte for the time period between years 2 and 3 by borrowing for eertia ‘amount of money for 3 years and lveting it for 2 years Compare two FRAS, The frit promises thatthe LIBOR forward rate fy will be received ona priacpal of“ betwoea times 7; and Ty; the second promise tht Ry wil be reeived on the atme principal between the same two dates The two cootmets tre the seme except forthe interest payracas eeivd at time TThe exces he onl of the second contract over the fin is, therefore, the present valu of te difference between these interest payments, or UR ReXTy~ Tye“ B® ‘where fis the continously compounded rskles ero rte fora matunty 7 Because the vale of the first FRA, where i eelved sro, the value ofthe mcond FRA, where My is ected, ie -3123,609 Vian = Ue ~ Re, — Te ®? a) ‘Similar, the value of en FRA where Ris pa s Vian = Lp ~ Ry XT — Tie? (410) By comparing equations (4.7) and (49), or equations (48) and (4.10), we se that an 5 Why the a at ty hese FRA et ited Noe ht Ry ty nd By are ert wih comgcuning eum crepe oP hard ‘yep kent coapoonsag Interest Rates ® FRA can be valued if we: 1. Calculate the pay onthe assumption that forward rates ae realized (that is, the assumption that Ry = fp) 2 Discount this payo atthe rsk-fee mt. ‘We wl ue this reslt when we value saps (which are porfolos of FRAs) in Chapter 7 Example 44 ‘Suppose that LIBOR zero and forward rates are as in Table 45. Consider an [FRA where we will receive arate of 6%, measured with annual compounding, and pay LIBOR on & principal of $100 milion between the end of year! and the end ‘of year 2. In this cas, the forward rate is 5% with continuous compounding or 5.127% with enauel compounding. From equation (4), it follows that the value of the FRA ie 100,000,000 x (0.06 — 0.05127}"#9*? = $805,800 4.8 DURATION ‘The dation of @ ond, a its name impli, isa measure of how long on average the Iholder of the bond bas to wait before receiving cash payments. A zero-coupon bond that lass n years as a duration of m years. However, a coupos-bearing bond lasting ‘years has & duration of ls than n years, because the holder receives some ofthe cash payments prior to yearn. ‘Suppose that a bond provides the holder with ash flows cy atime (<<). The ‘bond price B and bond ye y (continuously compounded) are related by a=Sae aa ‘The durtion of the bond, D, is defined as D. Stee" Eaise” a “This canbe written EET] Sie hee ere a PS ne ee roa eee aa eee ame a ee eee ae Sa aa ei Sas oie eas canter eo peas Se a ea eae eee ee Se eee eee ee eee ate Sores eres ee sas CHAPTER + approximately true that 413) From equation (4.11), this becomes p= (Note that there isa negative relationship between B and y, When bond yields increase, ‘bond prices deerease. When bond yields decrease, bond prices increase) From equa” ‘ions (4.12) and (4.14), the key duration relationship is obtained Day as p= ‘This ean be writen —Day 416) Equation (4.16) isan approximate relationship between percentage changes ina bond price and changes in it yield. Tt sens tote and is the reason Way duration, which as first suggested by Macaulay i 1938, as become such a popular measur ‘Consider 3-year 10% coupon bond with face value of $100. Suppote tat the yield ‘on the bond is 12% per annum with continuous compounding. This means that 12. Coupon payments of $5 are made every 6 months, Table 46 shows the Calculations necessary to determine the bond's damon. The present values of the bbon’s cash flows, using the veld a the laount rate ze shown in column 3 (eg the ‘resent value of the ist cashflow isSe"®!"* = 4708). The sum of the numbers in column 3 gives the bond's price as 94213. The weights are calculated by dividing the ‘number in column 3 by 94213, The sum ofthe numbers in cohumn$ gives the duration 35 2.653 yeas, ‘Small change in interest rates ae often measured in basi pons. AB mentioned cies, a bass point is 0.01% per annum. The following example investigates the accuracy ofthe duration relationship in equation (4.15). Table 4.6 Calculation of duration, Preset Weight Time x weight ale 47090050 0005 44350087 0087 4176 oom 0.066 3933 00a 0.083, 3m 0039 0.098 73255078 2333 34213, ——~1.000 2658 Inert Rates on Example 45 For the bond in Table 4.6, the bond price, #8 94.213 and the duration, D, 1 22683, so that equation (415) gives AB = 94213 x 2653 x ay AB =-2995x Ay ‘When the yield on the bond increases by 10 basis points (= 0.1%), dy = +0.00. ‘The dumtion elatonship predicts that AB = ~24995 x 0.001 = 0.250, so that the bond price goes down to 94213 ~0.250 = 93.963. How accurate is this? ‘Valuing the bond in terms of its yield in the usual way, we find that, when the bond yield increases by 10 base points o 12.1%, the bond price is SerPIOS 4 Sg BIMNLD gg QIehS ggg 81220 Fse-9 25.4 195¢-498 — 93963 which is (o tree decimal pleces) the sme as that predicted by the duration ‘lationship. Modified Duration ‘The preceding analyse a based on the assumption that y is expresied with continuous compounding If y 6 expresed with annual compounding, i can be shown thatthe proximate rationship in equation (4.15) becomes spay Sr arly; More pen iy peed wih eopounding eseny om ie per er _apay lym A vate DY ded by Ht Tm is sometimes fered oe the bond's mdf rato. alow th dation ration ‘hip tobe spied to p= -ao'ay an ‘when yi expressed with « compounding frequency of m times per year. The following example investigates the accurey ofthe modified duration reatoneip. Example 4.6 ‘The bond in Table 46 has a price of 94213 and a duration of 2.653. The yl ‘expremed with semiannual compounding is 123673% The modified duration, D*, i given by 2653 Troe 499 92 49 CHAPTER 4 AB = 94.213 x 24985 x Ay ‘When the yield (semiannually compounded) increases by 10 bass points (= 0.1%), 49.01. The duration relationship predicts that wecxpect A to be: 0.235, so that the bond price goes down to $4213 — 0.23 93978, How eocurae is this? An exact calculation similar to thin the previous ‘example shovs that, when the bond ye! (semiannually compounded) increases by TO bass points to 12.4673%, the bond price becomes 93.978. This shows thatthe ‘modified duration calculation gives good socuracy for small yield changes. ‘Another term that is sometimes used is dollar drarion. Tis ithe product of modified ‘duration and bond price, so that AB= ~D™ Ay, where D™ is dollar duration Bond Portfolios ‘The durntion, D, of bond portfolio can be defined as a weighted average of the durations ofthe individual bonds in the portfolio, with the weights being proportional to the bond prices. Equations (4.15) to (4.17) then apply, with B being defined ws the ‘value of te bond portoio. They estimate the change inthe value of th bond portfolio fora small change yin the yields ofall the bonds tis inportan to realize that, when duration is ued fr bond portfolios, thee is an implicit assumption that the yields ofall bonds will change by approxinatey the same mount. When ts bonds have widely difering maturities, this happeasonly when there isa parllel shit in the zero-coupon yield carve. We should therefore interpret ‘equations (4.15) (417) a8 providing estimates ofthe impact on the price of a bond portfolio ofa small paral shi, 4, inthe aso cure. ‘By chooring a portfolio to that the duration of ests equals the duraion of bilities (Ges the net duro ig zero), « nancial intuton eliminates is exposure to small ‘aril shift in the yield curv. But it ssl exposed to shifts that ar either large or sonpaiel CONVEXITY “The duration relaonship applies only to smal changes in yields. Tit is itatrated in Figure 42, which shows the reltionehip between the peeeatage change in value and change in vield for two bond portfolios having the same duration. The gradients of ‘the two curves are the same at the origin. This means that both 20nd portfolios ‘chang inva bythe same percentage for small yield changes and is consistent with ‘equation (416). Fr large yield changes, the portfolios behave dierety. Portfolio X Ines more carvate in its relationship with yeds than portfolio YA factor known as Ccomenity measur this curvature and can be used 10 improve the relationship in equation (416. "A measure of eoavexty is 93 Interest Rates Figure 4.2. Two bond portfolios with the same duration, From Tayor series expansions, we oblain a more accurate expretsion than eia- tion (413), given by This leads 10 Fora portfolio with a particular duration, the conveity ofa bond portoio tend to be greatest when the portfolio provides peymens evenly vera long period of time. I is leat when the payments we concertsted around ove particular polnt In time. By choosing a portfolio of emote and lilies with a net dumtion of zero and a net convesty of zo, « financial ination can make itl immune 10 relatively lege aralle hits inthe zero cure. However, it sll exposed to nonparll shi, 4.10 THEORIES OF THE TERM STRUCTURE OF INTEREST RATES Ten natu! to ak what determines the shape ofthe zero curve. Why i t sometimes owavard sloping, sometimes upward sloping, and sometimes petly upward slong and partly downward loping! A‘sumber af diferent theories have been proposed, The simplest i expectations theory, which conjectures that longterm inert rates shoud ‘fet expected future shor-erm interest rts, More precisely, targus that forward interest rate coresponding fo a certain Futur period sequal othe expected future ero interest rte for that perio. Another idea, marke segmentation theory, conjectures at CHAPTER + there need be no relationship between short, medium, and long-term interest rates. ‘Unde the theory, a major investor suchas a large pension fund invests in bonds of certain maturity and doesnot readily switch from one maturity to enotht. The short term interest ate is determined by supply and demand ia the short-term bond market; ‘the medium-term interes rates determined by supply and demand inthe medium-term bond market; and 50 on. ‘The theory that is most appealing i liuity preference theory The base assumption underlying the theory s that investors prefer to preserve thee guidty and invest funds for short periods of time. Rorrowern an theater hana, wally prefer to borrow at fae ‘ates for long periods of time. This lads toa situation ia whic forward ras are greater than expected future ero rates. The theory is also consistent with the empirical result that yield curves tend to be upward sloping more often than they are dowawar sloping, ‘The Management of Net Interest Income ‘To understand liquidity preference theory, i is useful to consider the interest rae risk faced by banks when they take deposits and make loans. The net intrest nome ofthe bank isthe exces ofthe interest recived over the interest pu and needs tbe carefully ‘managed. ‘Consider a simple situation where a bank offers consumers a one-year and a five-year deposit rate aswell a a one-year and five-year mortgage rats, The rates are shown in ‘Table 4.7, We make the simplying assumption thatthe expecied one-yeu interes rate for future time periods to equal the one-year rates prevailing in the market today ‘Loosely speaking this means thatthe market considers intrest fata cress tobe just ss ike as interest rate decreases. As resuly the rates in Table 47 ae “fair” in that they rect the market's expectations (ie, they corespond to expecatons theory) Investing money for ou year and reinvsting forfour further one-year pies give the same expected overall return as single five-year iavertment, Similars, borrowing ‘money for one year and refinancing each year forthe next four yar leads othe same expected financing cost as a single festa lan, ‘Suppose you have money to deposit and agee withthe prevaling view that interest ‘atc ineeass are just ab kely a8 interest rte decreases, Would you choot to deposit your money for one ear at 3% per anmum or for Bve years at 39 per snatam? The ‘chances are that you would choose one year because this gives you more financial ‘lexbilty. I es up your fund for ashorer period of time. "Now suppose that you want a mortgage. Again you agree with the prevaling view ‘that interest at incense are juss Uikely a intereat ratedecreases, ou’ you choose | one-year mortgage at 6% ofa five-year morigage at 624? The chances are that you ‘would choose a five-year mortgage because it es your Borrowing rte forthe net five years and subjects you to less refinancing risk. ‘When the bank posts the rte shown i Table 47, iti ely to find that the majority Table 4.7 Example of rates offered by « bento ie customers, Maturity (ears) Deposit rate Mortgage rate 1 i Go ame oe 3 % o% Interest Rates 9s Table 4.8 Fiveyear rates are increased nan attempt to match atures of assets and Habits, Masuty (years) Deposit rte Mortgage rate Y = 7% Dag ME 5 * ™ of its sustomers opt for one-year deposits and five-year mortgages. This erates an sssetlabity mismatch for the bank and subjetst to risks, Thee is no problem i interest rates fa. The bank will find itself fancing the five-year 6% loans with ‘eposis that cos less than 3% inthe future and net interest income will inenase Hower, if rates ris, the deposits that are financing these 6% loans will ox! mote than 3% in he future and net interest income will decline. A3% rise in intrest ates would ‘reduce the net interest income to zero. Its he ob ofthe asseiablty management group to ensure that the maturities of the astts on which interest is eired and the maturides of the lbilies on which interns pid are matched. One way it can do tis is by increasing the Bve-yeat rate on both deposits and mortgages. For example, it could move to the situation in Table 48 her te five-year deposit rat is 4% and the Bive-ear mortgage rate 7%. This would make fe-year deposits relatively more attnctive and one-year mortgages relay ‘more atractive, Some customers who chose one-year depots who the ats were ay ig ‘Table 47 will witch to five-year deposits in the Table 48 situation. Some customers ino chase veyear mortgages when theres were a in Table 47 wil choose ove yeas ‘mortgages, This may lad to the matures of assets and lables being matched If ‘here isl an imbalance with depositors tending to choose a one-year maturity and borrower a five-year maturity, fe year deposit and mortgnge rates could be inceased ‘even futher, Eventually the imbalance wil dsappear ‘The net result ofall banks behaving in the way we have just described is liquidity preferense theory, Long-term ates tend to be higher than the that would be preicied byexpeted futur short-term rats. The yield curve i upward sloping most of the dime It ‘is downvard sloping only when the market expect a seep deine n short-term rates. ‘Many banks now have sophisticated systems for monitoring the decsions being wade by customers so that, when they detect small diference between the mature of the assis and labilites being chosen by customers they can ine tune the rates they afer ‘Sometimes derivatives suchas interest rate swaps (which wil be discussed in Cheptze 7) ‘a alo asd to manage their exposure. The reuitof all hiss that net interest income ‘is usual ery stale, This has not always been the cas. Inthe United State, the fure ‘of Savings and Loan companies in the 1980 andthe failure of Continental Iinois i 1964 wer to a large extent a result ofthe fact that they didnot metch the matures of ‘assets and lables. Both fires proved tobe very expensive for US taxpayers Liquidity 1 adtinn to creating probes inthe way tat hes been deseo, a porolo where ‘atures re mismatched ca lea to qukity problems. Consider ance ait Soo that ands Syear Sized rt loans wth wholesale deposits that a oly 3 onthe 1 might engniae is exporure to sing interme and hedge it interme Tis ‘During the credit cri that started in July 2007 there wes a “ight to qual financial institutions and investors looked for safe investment than before to take credit risks, Financial institutions that relied on short‘crm funding experienced Iquidity problems. One examples Northern Rock inthe United Kingdom, which chore to ance much ofits mortgage portfolio with wholesale depois, some lasting only 3 months. Starting in September 2007, the depositors ‘became nervous and fused to oll ver the funding they wee providing to Northern ‘Rock, Leal th end of 3.month period they would refuse to epost their ands for further -month peiod. As result, Northern Rock wae unable to nance its eset 4 wus taken over by the UK government in carly 2008, In the US, financial institutions auch ax Bear Stearns and Lehman Brothers experienced similar liquidity problems because they had chosen to fund pat oftheir of ther operations with abort term funds, (Ore way of doing this by using interest rate swaps, as mentioned eae.) However, ‘ill ha a liquidity rik. Wholesale depositors may, for some reason, lose condense in the nancial insttuion and refwse to continue to provide the financial institution with shor-term funding. The financial institution, even if it has adequate equity pital, will then experence a severe liquidity problem that could led tits downfall ‘As described in Busines Soapsbot 4.3, thee type of lauidity problems were the Toot came of some of the flues of financial inaitutions during the crs thet started in 2007 SUMMARY ‘Two important interest rates for derivative traders are Treesry rates end LIBOR rates ‘Treanury mites ar the rates paid by e goverment on borrowings in its owm currency. LIBOR sates are short-term lending rats ofered by banks In the interbank markt. ‘Desiatves traders have tradhionlly assumed thatthe LIBOR mite is the shor er riskfne meat which funds ean be borrowed or lent. ‘The compounding frequency wed for an interest rte defines the units in which itis measured, The diflerence between en ansually compounded rate and « quartely ‘compounded mit is analogous to the difference between a disance measured in ile and a distance measured in kilometers. Trades frequently use continuous compound. ing when analyzing the value of options and more complex derivatives. ‘Many diferent types of interest rates are quoted in fing markets and calelaod by analysts. The m-yar zero or spot rat isthe rat appllcable o an invesipent lasting for ‘years when all ofthe return is realized atthe end, The pat yield on a bond of a eran ‘maturity isthe coupon rte that causes the bond to sellforits pa value Forward rates are ‘he rates applicable to future psiods of tie implied by today’s aro mt, ‘The method most commonly used to calculate zero mess known as th bootstrap ‘method, It iavolves starting with short-term instruments end moving progressively to Jonger-erm instruments, making sure that the zro rats calculated at each sage are Interest Rates ”

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