5.

Interest rate term structure

Term structure: how interest rate per year changes based on maturity of contract

Two types of contracts:

• Contract that start today => Spot
• Contract that is planned today but starts later => Forward

Spot rate: make a contract today

h(0,1) = 5% For one year contract, you will get 5% interest

h(0,3) = 7% For a three year contract, you will get 7% interest per year

Forward rate: plan and agree the contract today but it starts in the future

h(0) (1 , 2) = 6% Agreed today; start a contract next year up to second year

(overall for 1 year). You will get 6% interest
h(0) (2 , 5) = 8% Agreed today; start a contract in second year up to fifth year
(overall for 3 years). You will get 8% interest per year

Exercise: Consider the Interest term structure given by h(0) (0 , 1) = 2% and h(0) (0 , 2) = 3%

Find h(0) (1 , 2) = ?

0 1 2

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 x

3% + 3%

0 1 2

2% + X%

No Arbitrage Principle => two year contract = First year contract + Second year contract
3%+3% = 2% + x

=> x = 4% approximately

Compound: (1+i)t (1+0.03)2 = (1+0.02)1 * (1+x)1

4.0098% precisely

Discounting Using Spot rates:

Time 1 2 3
h(0 , 1) = i1 , h(0 , 2 ) = i2 , h( 0 , 3 ) = i3
CF CF1 CF2 CF3

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 Discounting Using Forward rates: Time 1 2 3
CF CF1 CF2 CF3
h(0 , 1) = i1 , h(1 , 2 ) = i2 , h( 2 , 3 ) = i3

Exerice2:
Consider the Interest Term Structure given by h(0) (0 , 1) = 2% and h(0) (0 , 2) = 3%

Time 0 1 year 2 year

CF 5$ 105$

h(0,1) h(0,2)

2% 3%

Exercise 3: Consider the Interest term structure given by h(0) (0 , 1) = 2% and h(0) (0 , 2) = 3%

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 (with two instalments , starting from first year from now)

Price today = PV of instalments

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 Price today = PV of future CF

Time 0 1 2 3
CF 3 3 103

1% 2% 2.5%

NPV using spot and forward rates: Time 0 1 2 3

CF CF0 CF1 CF2 CF3

opportunity cost changes for each year => Generalized NPV => GNPV

Spot rates h(0 , 1) = i1 , h(0 , 2 ) = i2 , h( 0 , 3 ) = i3

Forward rates h(0 , 1) = i1 , h(1 , 2 ) = i2 , h( 2 , 3 ) = i3

Or in question is mentioned: Interest rate of each period

Decision: Investment (or Loan) is convenient if GNPV > 0

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 Forward rates

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