Interest Rates and Exchange Rates

Class Notes (FN6411) : Sris Chatterjee

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[A] Average (Representative) Returns

(a) Arithmetic Return

(b) Geometric or Time-Weighted Return
(c) Internal Rate of Return (IRR) or Money-Weighted Return

Arithmetic Return:

Suppose an asset (such as a share of IBM) had the following returns:

Year Rate of Return

1999 5%
2000 –3%
2001 2%
2002 4%
2003 7%

Then, the Arithmetic Return = (5-3+2+4+7)/5 = 3%

Geometric Return:

The Geometric Return takes into account the compounding of interest. In the
example above, if R is the annual Geometric Return, then:

(1 + R)5 = (1.05)(0.97)(1.02)(1.04)(1.07) = 1.1561

and R = (1.1561)(1/5) – 1 = 2.9427%

Money-Weighted Return or IRR:

Suppose we don’t have rates of return as our input data. Suppose, instead, that we
have data on money inflow and outflow. For example, an investor puts in $10,000
today into a hedge fund and another $5000 into the same fund at year-end. The
fund pays him $1000 at the end of the 2nd year, $2000 at the end of the 3rd year
and then a final payment of $18,000 at the end of the 4th year. How should we
compute a representative annual rate of return? IRR provides this answer.

0 1 2 3 4

- 10000 - 5000 1000 2000 18000

If IRR = R, then R must satisfy the following equation which says that the PV of all cash
outflows equals the PV of all cash inflow:

10000 + 5000/(1 + R) = 1000/(1 + R)2 + 2000/(1 + R)3 + 18000/(1 + R)4

There is no general mathematical formula to solve for R which must be computed by

“trial & error” method. Fortunately, this tedious task is easily done by the calculator or
the Excel.

In the example above: R = 10.1693%

Important Comments:

(1) The IRR is a purely mathematical construct. The implicit economic assumption is
that all cash earnings are reinvested at the same rate. If that is not the case, then
the IRR does not have much economic meaning and one should use other
concepts such as Realized Compound Yield (or RCY, on which see below).

(2) The Yield to Maturity (YTM) on a bond is actually an IRR. For example, what is
the YTM on a 6% annual coupon bond if the bond matures in 10 years and if it is
currently selling for 95% of face value?

Answer:

0 1 2 3 4 5 6 7 8 9 10

-950 60 60 60 60 60 60 60 60 60 1060

This gives an YTM = 6.7021%

Remember:

This number implicitly assumes that the bond investor is able to earn 6.7021% by
reinvesting the $60 coupons. The actual return on a 10-year holding period will be higher
if the coupons can be reinvested at a higher rate. This leads to the next comment
regarding RCY.

(3) Suppose the bond investor is able to reinvest the coupons at 7% per annum for the
next 10 years. Then total FV of all reinvested coupons and the principal
repayment equals $1828.9869. On an initial $950 investment, this translates to an
actual return of (1828.9869/950)0.1 – 1 or 6.77%. Therefore, the RCY on the bond
is 6.77%.
[B] Term Structure of Interest Rates

1. Basic Idea:

The basic idea is that the rate of interest (or yield) depends upon the term to maturity
(holding other factors constant). We commonly observe that 10-year Treasury Bonds
offer a higher yield than a one-year T-Bill. In other words, the term structure of
interest rates (or the yield curve) is commonly upward sloping (although the yield
curve may be downward sloping at times). It is also possible that the yield curve is
upward sloping for Treasuries, but downward sloping for a very low-grade Corporate
bond.

The theoretically correct yield curve is derived from zero-coupon bonds (or zeros).
The reason behind this practice is that coupon bearing bonds have a so-called
“coupon effect” on their YTMs (more on this later).

STRIPS form an important class of zero-coupon instruments. An investment bank

may buy a coupon paying 10-year Treasury and create 10 zero-coupon bonds. These
securities are called STRIPS (Separately Traded Registered Interest and Principal
Securities).

Suppose we observe the following prices for zero-coupon bonds of various maturities

Maturity (in years) Price as a % of Par

1 98.5%
2 96.25%
3 93.5%
4 90.6%

Then the zero-coupon yield curve will be:

Maturity (in years) Yield (in %)

1 1.5228
2 1.9294
3 2.2656
4 2.4986

2. Coupon Effect:

Take the 4-year zero-coupon yield curve from above. What will be the YTM on a 4-
year 6% coupon bond? What will be the YTM on a 4-year 1% coupon bond?

Answer (assume a $1000 face value):

The current price of the 6% coupon bond

= 60(0.985) + 60(0.9625) + 60(0.935) + 1060(0.906) = 1133.31

Therefore: its YTM = 2.4598%

The current price of the 1% coupon bond

= 10(0.985) + 10(0.9625) + 10(0.935) + 1010(0.906) = 943.885

Therefore: its YTM = 2.4913%

Important Note: When the yield curve is rising (upward sloping), a lower coupon
bond has the higher YTM compared to a high-coupon bond. The reverse is true when
the yield curve is downward sloping. This is known as the coupon effect on YTM.

3. Reading the Yield Curve & Forward Rates:

See the example on page 216 of the text.

[C] Components of Interest Rates

The approximate formula is:

Nominal Rate = Pure Rate + Inflation Premium + Various Risk Premia

See the exact formula on page 206.

For a bond investment, the following risk factors may apply:

(1) Default risk (bankruptcy, non-payment of interest, technical default, etc)

(2) Interest rate risk (price risk, reinvestment risk, reset risk, etc)
(3) Currency risk (if coupons are paid in a different currency)
(4) Liquidity risk (if the bond is thinly traded)
(5) Other factors such as prepayment risk in some cases

For a stock investment, it is useful to classify risk as market risk and non-market risk.
(We’ll have more to say on this topic later).
[D] Exchange Rates

1. Direct rates and Reciprocal rates:

2. Reuters Convention:

USD|CHF = 1.2375 (which means that $1 = 1.2375 CHF)

GBP|USD = 1.8406 (which means that 1 GBP = $1.8406)

Question: Is there an opportunity for triangular arbitrage with the rates above if you
are also told that GBP|CHF = 2.30? Show the arbitrage trade.

3. Bid-Ask Spread:

Suppose you want to convert 10,000 CHF to Indian Rupees, but the bank is unable to
give you a quote. However, the bank has the following quotations available:

USD|CHF = 1.2375 – 85
USD|Indian Rupee = 44.0050 – 70

How many Rupees will you get from your 10000 CHF with these quotes?

4. Interest Rate Parity Theorems:

(a) Covered Interest Arbitrage (with forward exchange rate)

(b) Uncovered Interest Arbitrage (with expected future spot rate)

5. Purchasing Power Parity: