Exercise Session 7. Solution.

Fixed Income and Credit Risk

Question 1. Define n−times compounded interest rate rn (t, T ) using the following identity
 −n(T −t)
rn (t, T )
Z(t, T ) ≡ 1+ ,
n

where Z(t, T ) is a discount factor between dates t and T .

• Call r(t, T ) ≡ limn→∞ rn (t, T ) a continuously compounded interest rate. Derive the expression for Z(t, T )
as a function of r(t, T ). Invert it to express the continuously compounded rate as a function of the discount
factor.
Use the fact that  x n
ex = lim 1+
n→∞ n
to write down Z(t, T ) as a function of r(t, T ):

Z(t, T ) = e−r(t,T )(T −t) .

It follows immediately that

ln Z(t, T )
r(t, T ) = − .
(T − t)

• Express the n−times compounded rate as a function of the continuously compounded rate and vice versa.
Take a second order Taylor approximation of rn (t, T ) as a function of r(t, T ) to quantify the approximate
difference between rn (t, T ) and r(t, T ).
n−times compounded rate given the continuously compounded rate:
 r(t,T ) 
rn (t, T ) = n e n − 1 .

Continuously compounded rate given the n−times compounded rate:

 
rn (t, T )
r(t, T ) = n ln 1 + .
n

Take a Taylor expansion of the exponential to the second-order term:

 2 !
r(t, T ) 1 r(t, T ) 2


rn (t, T ) = n 1 + + + o r(t, T ) −1
n 2 n
1
r(t, T )2 + o r(t, T )2 ⇒


= r(t, T ) +
2n
1
r(t, T )2 + o r(t, T )2 .


rn (t, T ) − r(t, T ) =
2n

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Question 2. Obtain the discount curve from the following data (assume a par of 100 for all the bonds below):

1. Zero-coupon bond maturing in 6 months that trades today at price P1 = 99.2000;

2. 3% coupon bond with coupons paid quarterly maturing in one quarter that trades today at price P2 =
100.5485;

3. 6% coupon bond with coupons paid quarterly maturing in three quarters that trades today at price P3 =
100.1655;

4. 5% coupon bond with coupons paid semiannually maturing in one year that trades today at price P4 =
100.0325.

Plot the discount curve. Compute continuously, annually, semi-annually, and quarterly compounded interest rates
that correspond to the discount curve above, plot the corresponding yield curves. For the 6% coupon bond describe
quantitatively the evolution of the difference between dirty prices and clean prices from today to maturity.

Construct the payment matrix C:  

0 100 0 0
 
 100.75 0 0 0 
 
 1.5 1.5 101.5 0 
 
0 2.5 0 102.5

and find the vector of discount factors Z 0 = [Z(0.25) Z(0.5) Z(0.75) Z(1.00)] by solving P = CZ:
     
99.2000 0 100 0 0 Z(0, 0.25)
     
 100.5485   100.75 0 0 0   Z(0, 0.5) 
·
 100.1655  =  1.5
   .
   1.5 101.5 0    Z(0, 0.75)
 

100.0325 0 2.5 0 102.5 Z(0, 1)

for Z, i.e., Z = C −1 P. Then use the formulas for rates and discount factors from Question 1. The results are given
in the table below, also plotted.

3m 6m 9m 12m
Discount factor 0.9980 0.9920 0.9574 0.9517
Continuously compounded rate 0.8008 1.6064 5.7985 4.9472
Quarterly compounded rate 0.8016 1.6097 5.8407 4.9779
Semi-annually compounded rate 0.8024 1.6129 5.8834 5.0089
Annually compounded rate 0.8040 1.6194 5.9699 5.0716

Table 1: Discount curve and yield curves.

For the accrued interest, use a regular formula

c t − Ti−1
AI(t) = · ,
n Ti − Ti−1

where c is a coupon rate, n is the frequency of coupon payments, Ti−1 is the previous coupon date and Ti is the
next coupon date. Hence, between coupon payment dates, accrued interest evolves linearly from zero to coupon
payment amount. The plot is given below.

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 Discount curve Interest rate curve
● 6 Continuous ●
●
●
●
Annual
Semi−annual
●
Quarterly
0.99 5
●
●
●
●

Interest rate, %
Discount factor

0.98

3
0.97

2
0.96 ●
●

1
● ●
0.95
3m 6m 9m 12m 3m 6m 9m 12m

Horizon Horizon

Figure 1: Discount curve and yield curves.

2020−04−26 / 2021−01−26

1.0

0.5

26 01 01 01 01 01 01 01 01 26
Apr Jun Jul Aug Sep Oct Nov Dec Jan Jan

Figure 2: Accrued interest

Question 3. You are given the following information on discount factors:

T 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Z(0, T ) 0.9780 0.9460 0.9140 0.8830 0.8545 0.8275 0.8024 0.7791

Fit the standard Nelson-Siegel model to the implied continuously-compounded rates r(0, T ) and using your result,
extend the above table up to T = 10 in a similar semi-annual fashion.

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The Nelson-Siegel model assumes the following parametrization for the yield curve:
T
1 − e− λ T
r(0, T ) = f (θ1 , θ2 , θ3 , λ; T ) = θ0 + (θ1 + θ2 ) T
− θ 2 e− λ .
λ

Given discount factors Z(0, T ), we compute r(0, T ) = − ln Z(0,T

T
)
, and then solve a least-squares-type optimzation
problem
N
X 2
(r(0, Ti ) − f (θ1 , θ2 , θ3 , λ; Ti )) → min .
θ1 ,θ2 ,θ3 ,λ
i=1

Solving such optimization problem requires some numerical software (Excel won’t do the job because it is a multi-
variate optimization problem). You will find a sample solution in R on Moodle. The solution yields:

θ̂1 = 0.05913430, θ̂2 = −0.03754789, θ̂3 = 0.05753829, λ̂ = 0.73319532.

Mind that numerical results may differ slightly depending on the type of optimization routine used.
Once you have a fitted curve f (θ̂1 , θ̂2 , θ̂3 , λ̂; T ), plug the values for T > 4 to get the extended curve. The results
are presented below.

T Z(0,T) r(0,T)
0.5 0.9780 0.0445
1.0 0.9460 0.0555
1.5 0.9140 0.0599
2.0 0.8830 0.0622
2.5 0.8545 0.0629
3.0 0.8275 0.0631
3.5 0.8024 0.0629
4.0 0.7791 0.0624
4.5 0.7557 0.0623
5.0 0.7334 0.0620
5.5 0.7120 0.0618
6.0 0.6912 0.0616
6.5 0.6710 0.0614
7.0 0.6514 0.0612
7.5 0.6325 0.0611
8.0 0.6140 0.0610
8.5 0.5961 0.0609
9.0 0.5788 0.0608
9.5 0.5619 0.0607
10.0 0.5455 0.0606

Table 2: Extended discount curve and yield curve.

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 Discount curve Interest rate curve
● ● ●
●
● ● ●
●
● ● ● ● ● ● ● ● ● ● ●
●
0.9 6.0 ●

●
Interest rate, %
Discount factor

0.8 ● ●
5.5
●

●
0.7 ●
● 5.0
●
●
●
0.6 ●
●
●
4.5
● ●

0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5

Horizon Horizon

Figure 3: Extended discount curve and yield curve.