Fixed Income Analytics

Wolfgang
Marty
Fixed
Income
Analytics
Bonds in High and Low Interest Rate
Environments
Fixed Income Analytics
Wolfgang Marty
Fixed Income Analytics

Bonds in High and Low Interest Rate
Environments
Wolfgang Marty
AgaNola AG
Pfaeffikon
Switzerland
ISBN 978-3-319-48540-9 ISBN 978-3-319-48541-6 (eBook)

DOI 10.1007/978-3-319-48541-6
Library of Congress Control Number: 2017952064
# Springer International Publishing AG 2017

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Foreword
In light of an investment environment characterized by low yields and new regu-

latory capital regimes, it has become increasingly demanding for investors to
achieve sustainable returns. Particularly, fixed income investments are called into
question. There is a solution.
Since the foundation of AgaNola a decade ago, we have put our interest into
convertibles, and at this point we want to thank our clients for having supported us
also in challenging times—particularly when convertible bonds were considered at
most a niche investment. Unjustly!
For being a hybrid, convertible bonds offer the “best of both worlds,” the
benefits of an equity with the advantages of a corporate bond. AgaNola is consid-
ered a leading provider in this asset class, and to date convertible bonds remain the
core competence of us as a specialized asset manager.
As we consider increasingly popular convertible bonds a living and dynamic
universe, we are placing a great importance on research and the exploration of the
nature of this asset class. As an internationally renowned expert in the fixed income
and bond field, Dr. Wolfgang Marty has contributed valuable insights to our
work—making the bridge from theory to portfolio management. AgaNola is
committed to continue to support his fundamental research.
We wish Wolfgang Marty lots of success with his latest book.
Chairman and Founder AgaNola AG Stefan Hiestand
v
Foreword
Compared to other asset classes, fixed income investments are routinely considered
as a relatively well-understood, transparent, and (above all) safe investment. The
notions of yield, duration, and convexity are referred to confidently and resolutely
in the context of single bonds as well as bond portfolios, and the effects of interest
rates are generally believed to be well-understood.
At the same time, we live in a world where the amount of private, corporate, and
sovereign debt is steadily increasing and where postcrisis stimuli continue to affect
and distort investor behavior and markets in an unprecedented way. And that is
even before we start contemplating the enormous uncertainties introduced by
negative interest rates.
In his book, Dr. Wolfgang Marty covers and expands on classic fixed income
theory and terminology with a clarity and transparency that is rare to be found in a
world where computerization of accepted facts often is the norm. Wolfgang
highlights obvious but commonly unknown conflicts that can be observed, for
example, when applying standard theory outside its default setting or when migrat-
ing from single to multiple bond portfolios. He also includes the effects of negative
interest rates into standard theory.
Wolfgang’s book makes highly informative reading for anyone exposed to fixed
income concepts, be it as a portfolio manager or as an investor, and it shows that
often we understand less than we think when studying bond or bond portfolio
holdings purely based on their commonly accepted key metrics; Wolfgang
encourages to ask questions. Anyone building automated software would benefit
from familiarity with the model discrepancies highlighted as it is to everyone’s
disadvantage if we find these too deeply rooted in commonly and widely applied
tools.
In summary, Wolfgang’s book makes interesting reading for the fixed income
novice as well as the seasoned practitioner.
Head of Quantitative Research Dr. Jan Hendrik Witte

Record Currency Management
vii
Preface
Computers have become more and more powerful and often are an invaluable aid.
But there is a considerable disadvantage: often, the output of a computer program is
difficult to understand, and the end user may be swamped by data. In addition,
computers solve problems in many dimensions, and, as human beings, we struggle
thinking in more than a few dimensions. To provide a sound background of
understanding to anyone working in fixed income, we intend to illustrate here the
essential basic calculations, followed by easy to understand examples.
The reporting of return and risk figure is paramount in the asset management
industry, and the portfolio manager is often rewarded on performance figures. The
first motivation for the here presented material were the findings of a working group
of the Swiss Bond Commission (OKS), where we compared the yield for a fixed
income benchmark portfolio calculated by different software providers: we found
different yields for the same portfolio and the same underlying time periods. The
following questions are obvious: How can a regulating body accept ambiguous
figures? Should there not be a standard?
An additional complication is linearization, often the first step in analyzing a
bond portfolio. The yield of the bonds in a bond portfolio is routinely added to
report the yield of the total bond portfolio, and different durations of bonds in the
portfolio are simply added to indicate the duration of a bond portfolio. We found
that linearization works well for a flat yield curve, but the more the yield deviates
from a flat curve, the more the resulting figures become questionable.
Also, historically, interest rates have been positive. In the present market
conditions, however, interest rates are close to zero or even slightly negative. We
find ourselves confronted with several questions: Does the notion of duration still
make sense in this new environment? And which formulae can be applied for
interest rates equal or very close to zero? How do discount factors behave? In the
following, we attempt to include negative interest in our considerations. For
instance, in the world of convertibles, yield to maturities can easily be negative
and is not problematic.
ix
x Preface
We describe the here presented material in three ways. Firstly, we use words and
sentences, in order to give an introduction into in the notions, definitions, ideas, and
concepts. Secondly, we introduce equations. Thirdly, we also use tables and figures
in order to make the outputs of our numerical calculations accessible.
Pfaeffikon SZ, Switzerland Wolfgang Marty

July 18, 2017
Acknowledgments
This book is based on several presentations, courses, and seminars held in Europe
and the Middle East. The here presented material is based on a compilation of notes
and presentations. Presenting fixed income is a unique experiment and I am grateful
for the many feedbacks from the audience. The initial motivation for the book was a
seminar held at the education center of the SIX Swiss Exchange. I became aware
that many issues in fixed income need to be restudied and revised; moreover, I did
not find satisfying answers to my questions in the pertinent literature. The SIX
Swiss Exchange Bond Advisory Group was an excellent platform for analyzing
open issues.
Furthermore, the working group “Portfolio Analytics” of the Swiss Bond Com-
mission was instrumental for the research activities. In particular my thanks go to
Geraldine Haldi, Dominik Studer, and Jan Witte. They revised part of the manu-
script and provided helpful comments.
The European Bond Commission (EBC) was very important for my professional
development. The members of the EBC Executive Committee Chris Golden and
Christian Schelling gave me continuing support for my activities, and the EBC
sessions throughout Europe yielded important ideas for the book.
At the moment I am focusing on convertibles. My thanks go to Marco Turinello
and Lukas Buxtorf for introducing me into the analytics of convertibles. The last
chapter of the book is dedicated to convertibles.
The book was written over several years, and I am grateful to my present
employer AgaNola for the opportunity to complete this book.
xi
Conventions
This book consists of eight chapters. The chapters are divided into sections. (1.2.3)
denotes formula (3) in Sect. 1.2. If we refer to formula (2) in Sect. 1.2, we only write
(2); otherwise we use the full reference (1.2.2). Within the chapters, definitions,
assumptions, theorems, and examples are numerated continually, e.g., Theorem 2.1
refers to Theorem 1 in Chapter 2.
Square brackets [ ] contain references. The details of the references are given at
the end of each chapter.
xiii
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 The Return Over a Time Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3 Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3 The Flat Yield Curve Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1 The Description of a Straight Bond . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Yield Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3 Duration and Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.4 The Approximation of the Internal Rate of Return . . . . . . . . . . . . 55
3.4.1 The Direct Yield of a Portfolio . . . . . . . . . . . . . . . . . . . . . 57
3.4.2 Different Approximation Scheme for the Internal
Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
3.4.3 Macaulay Duration Approximation Versus Modified
Duration Approximation . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.4.4 Calculating the Macaulay Duration . . . . . . . . . . . . . . . . . . 89
3.4.5 Numerical Illustrations . . . . . . . . . . . . . . . . . . . . . . . . . . 93
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
4 The Term Structure of Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . 103
4.1 Spot Rate and the Forward Rate . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.2 Discrete Forward Rate and the Instantaneous Forward Curve . . . . 107
4.3 Spot Rate and Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.4 The Effective Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
5 Spread Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.1 Interest Rate Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.2 Rating Scales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
5.3 Composite Rating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.4 Optionality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
xv
xvi Contents
6 Different Fixed Income Instruments . . . . . . . . . . . . . . . . . . . . . . . . . 149

6.1 Segmentation of the Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . 149
6.2 Floating Rate Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
6.3 Interest Rate Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
6.4 Asset Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
7 Fixed-Income Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
7.1 Definition and Fundamental Properties . . . . . . . . . . . . . . . . . . . . 159
7.2 Constructing a Fixed-Income Benchmark . . . . . . . . . . . . . . . . . . 160
7.3 Recent Developments in the Benchmark Industry . . . . . . . . . . . . . 162
7.4 Fixed Income as Asset Class . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
7.4.1 Equity Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
7.4.2 Fixed-Income Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
7.4.3 Hedged Fixed-Income Indices . . . . . . . . . . . . . . . . . . . . . 167
7.4.4 Commodity Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
8 Convertible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
8.1 Basics Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
8.2 The Stock Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
8.3 The Bond Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
8.4 The Embedded Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
About the Author
Wolfgang Marty is senior investment strategist at AgaNola, Pfaeffikon SZ,

Switzerland. Between 1998 and 2015, he was working with Credit Suisse. He joined
Credit Suisse Asset Management in 1998 as head product engineer. He specializes
in performance attribution, portfolio optimization, and fixed income in general.
Prior to joining Credit Suisse Asset Management, Marty worked for UBS AG in
London, Chicago, and Zurich. He started his career as an assistant for applied
mathematics at the Swiss Federal Institute of Technology.
Marty holds a university degree in mathematics from the Swiss Federal Institute
of Technology in Zurich and a doctorate from the University of Zurich. He chairs
the method and measure subcommittee of the European Bond Commission (EBC)
and is president of the Swiss Bond Commission (OKS). Furthermore, he is a
member of the Fixed Income Index Commission at the SIX Swiss Exchange and
a member of the Index Team that monitors the Liquid Swiss Index (LSI).
xvii
Introduction
1
A fixed-income security is a financial obligation of an entity that promises to pay a

specified sum of money at specified future dates. The entity can be a government, a
company, or an individual and is called an issuer. The investor lends a specified
amount of money to the issuer. A bond is a legal engagement between the issuer and
an investor.
A bond is a fixed-income instrument and has usually a finite live. Periodic future
cash flows from the issuer to the investor are called the coupon of the bond.
Coupons are unaffected by market movements for the live of the bond and reflect
the notion “fixed income.” As depicted in Fig. 1.1, a straight bond or a coupon
paying bond is a bond that pays a coupon periodically and pays back at the end of its
live the money that was originally invested. For precise definitions and analytics,
we refer to Chap. 3.
The bond markets have grown tremendously, and today there is a large universe
of organizations that issues bonds. Together with equities, bonds are the two major
traditional asset classes in financial markets. There are much different bonds than
equities. For instance, there were 5447 shares traded and admitted to trading on the
EU regulated market (mifiddatabase.esma.europa.eu), and TRAX has data for
300,000 government bonds, corporate bonds, medium-term notes, and private
derivative issues (xtrakter.com).
The time to maturity and the coupon are fixed at the issuance of a bond and are
thus called static data or reference data, whereas the market price is determined by
the trading activity and is thus called market data.
Unlike equities, every bond has potentially special and unique features. A
company has one or two kinds of equities but many different bonds. Bond markets
are very fragmented. Figure 1.2 (see www.sifma.org/research/statistics.aspx) shows
the development of the four most important segments of the US Bond Market. Ever
since interest rates began to climb in the late 1960s, the appeal for fixed-income
instrument has increased. This is due to the fact that interest levels were competitive
with other instruments, and at the same time, the market rates began to fluctuate
widely, providing investors with attractive capital gain opportunities emphasizing
# Springer International Publishing AG 2017 1

W. Marty, Fixed Income Analytics, DOI 10.1007/978-3-319-48541-6_1
2 1 Introduction
cash
flows
Original
investment
coupon coupon coupon coupon Original time

Investment +
coupon
Fig. 1.1 Straight bonds
Outstanding U.S. Bond Market Debt

14,000.0
12,000.0
10,000.0
Municipal
8,000.0
Treasury
6,000.0 Mortgage Related
4,000.0 Corporate
2,000.0
0.0
1980 1985 1990 1995 2000 2005 2010
Fig. 1.2 The development of the US bond market
that fixed income is not necessarily fixed income. Only for the buy and hold
investor, i.e., the investor who keeps the bond till maturity, cash flows are fixed.
The here presented material gives a comprehensive introduction to fixed-income
analytics. Some of the topics are:
• The transition from a single bond to portfolio of bonds is examined. We

investigate the nonlinearity of income since just adding characteristics of indi-
vidual bonds yields in general wrong results for the overall portfolio.
• We consider market-relevant values for interest rates and examine different
shape of the yield curve. In particular, we discuss negative interest rates.
• We introduce the main ideas for assessing the credit quality of a bond. We
compile different definitions of the default of a bond.
• We describe the construction of an income benchmark and give an overview of
different benchmark providers.
1 Introduction 3
We now provide more detail about the different chapters of this book.
Chapter 2 describes the time value of money. This chapter contains the building
blocks of a fixed-income instrument. We introduce the concept of an interest rate.
We stress specifically that throughout this book and all its results, we treat negative
and positive interest rates with generality (rather than favoring positive interest
rates as has been so common in the literature until now).
In Chap. 3, the flat yield curve concept is explained, i.e., every cash flow is
discounted by the same interest rate. This does not mean that the yield curve is flat.
If all bonds have the same yield, the yield curve is said to be flat. We discuss
deviation of the flat yield curve.
The yield to maturity is a well-established measurement for indicating a bond’s
future yield. It is derived from the coupon, the nominal value, and the term to
maturity of the bond.
Portfolio analysis frequently refers to the “yield.” The question is which yield?
In the following, we will not focus on a single bond. Rather, we will examine the ex
ante yield of an entire bond portfolio, i.e., exclusively future cash flows are factored
into the calculation. The equation for yield to maturity will be generalized to derive
an equation for the bond portfolio (internal rate of return). This equation is not
solved exactly by the programs offered by most software providers; instead, it is
considered in combination with the yields to maturity of the individual bonds.
In Chap. 4, we speak about the transition from yield curve to spot curves and spot
curves to forward curves (see Fig. 1.3). Figure 1.3 refers to a specific time and does
not say anything about the dynamic of the curve. Actual prices are measured in the
marketplace, and yield, spot, and forward curve are in general calculated or
computed. Duration is a risk measure of bonds and bond portfolios. Here, we assess
the durations in the context of a bond and a portfolio of bonds. Effective duration
versus durations based on the flat yield concept is discussed. Modified duration is
Fig. 1.3 Different interest

rate term structures
forward rate
spot rate
yield to maturies
4 1 Introduction
used for a sensitivity analysis of a bond portfolio. The different durations we

introduced tackle the interest risk and the yield curve risk. The duration is the
fulcrum of a bond and can be compared to an equilibrium in physics.
In Chap. 5, we depart from the assumption that a straight bond is riskless. We
consider credit markets. The credit quality of a bond is described by different
spreads. We introduce the normal spread and the Z-spread and give the definition
of default of a bond from S&P, Moodys, and Fitch. More recent developments of
credit markets are described. We illustrate some figures from a transition matrix and
discuss composition ratings followed by the description of call and put features of
a bond.
In Chap. 6, we start with float rate notes. Unlike fixed coupons, floating rates are
tied to the short end of the yield curve. We give an introduction in the analytics of
floating rate notes. We then proceed with the interest rate swap, which exchanges
the liability of two counterparties. Interest swap markets are important for steering
the duration of a bond portfolio. In the last section of the chapter, asset swaps are
described.
Starting point in Chap. 7 are the basic characteristics of a benchmark. An
overview of different benchmark providers is given. We describe benchmarks
from different asset classes and discuss benchmarks for a balanced portfolio. We
give more recent developments in the benchmark industry.
In Chap. 8, we give an introduction into convertible bonds. Convertible is
corporate bond with an option on the stock of the issuing company. Convertibles
can behave like a bond as well as a stock. We compile the most important notions
describing a convertible. Difficulties of pricing a convertible are discussed.
The Time Value of Money
2
In this chapter, we introduce the basic notions and methods for assessing fixed-
income instruments. The subject of this chapter is the connection between time and
the value of money.
2.1 The Return Over a Time Unit
Return measurement always relates to a time span, i.e., it matters whether you earn
a specific amount of money over a day or a month. Therefore, return measurement
has to be relative to a unit time period. In finance, the most prominent examples are
a day, a month, or a year. In Fig. 2.1 we see a unit time period and a partition into
four time spans of the same length.
With a beginning value BV and a yearly or annular interest r, we write
EV1 ¼ BVð1 þ rÞ ð2:1:1Þ
for the ending value EV1. The underlying assumptions of (1) are that:
• We hold the beginning value over one year.

• There is no interest payment and no cash flow during the year.
Example 2.1 We consider for BV a Coupon C of an annual paying bond. Then

(1) expresses the ending value EV1 after 1 year. In the European bond market,
coupons are usually paid yearly.
The index 1 in EV1 says that there is no cash flow during the year and EV1.
Next, we assume that one half of the interest is pay out in the middle of the year,
which gives

6 2 The Time Value of Money
Fig. 2.1 The time unit t1 = 0.25 t3 = 0.75
t0 = 0 t2 = 0.5 t4 = 1 t
h

r i r r2
EV2 ¼ BV 1 þ : 1þ ¼ BV 1 þ r þ :
2 2 4
Here, we have a reinvestment assumption about the middle of the year: we

assume that the money received is reinvested with the same interest rate r. We
observe that EV2 > EV1, and we proceed by iterating and taking the limit:

1 n
EV ¼ BV lim 1þ , n ¼ 1, 2, 3, . . .
n!1 n
The question is whether the sequence EVn is bounded or unbounded. The answer
is that the sequence is convergent since from calculus we know that

1 n
lim 1 þ ¼e
n!1 n
with
e ¼ 2:71828 18284 5905:
From calculus we also have
r
r n 1 nr 1 n
lim 1 þ ¼ lim 1 þ ¼ lim 1þ ¼ er :
n!1 n n!1 n n!1 n
Hence, when compounding with an infinitely small compounding interval, the

continuous compounding expression becomes
EV1 ¼ BVer :
Example 2.2 For r ¼ 0.05 (¼5% annually) and BV ¼ $100 we get in decimals
EV2 ¼ $105.06250 (semi-annual).

EV4 ¼ $105.09453 (quarterly).
EV100 ¼ $105.1257960.
EV1000 ¼ $105.1269782.
EV10000 ¼ $105.1270965.
2.2 Discount Factors 7
EV100000 ¼ $105.1271083.
EV1 ¼ $105.1271109 (continuous).
Definition 2.1 The return
EVn BV
AERðnÞ ¼ , n ¼ 1, 2, 3, . . .
BV
is called the annual effective rate.
Remark 2.1 For discrete compounding, we have
EVn BV EVn r n
AERðnÞ ¼ ¼ 1¼ 1 þ 1, n ¼ 1, 2, . . . :
BV BV n
and for continuous compounding, we have with n!1
AER ¼ er 1:
Example 2.3 We consider a semiannual bond with face value F 1 year before
maturing. Furthermore, we assume there are two coupons, i.e., we get C/2 in the
middle of the year and C/2 at the end of the year. By using continuous compounding
and prevailing interest r1 and r2, we find

C r1 C r2
P¼ e þ Fþ
2 e :
2 2
2.2 Discount Factors
The time value of money concept is concerned with the relationship between cash
flow C occurring on different dates. If C > 0 or C < 0, the investor has an inflow or
outflow, resp., in his or her portfolio. The cash flow can occur at arbitrary different
dates. A simple time pattern is depicted in Fig. 2.1. In Fig. 2.2, we introduce N time
knots between the time knot t0 and tN, where the time t is the independent variable.
We specify N (not necessarily equidistant) knots on the time axis with
corresponding times tk and denote them by
tk , 0 k N: ð2:2:1Þ
By assuming t0 ¼ 0, t0 is the present or for short t0 is now. However, in principle,

t0 can be in the past (t0 < 0) or in the future (t0 > 0). For illustration purposes, we
use years as units. Then, for equidistant knots of annual cash flows between t0 and
tN, we have
equidistant knots
t
t0 = 0 t1 t2 tk tN tN = T
1
Fig. 2.2 The time axis
tk ¼ k, 0 k N: ð2:2:2Þ
For two equidistant knots over 1 year, we have N ¼ 2, and the time knots are
marked by
1
t1 ¼ ,
2
t2 ¼ 1:
Definition 2.1 The discount factor function or for short the discount factor
d(r(t tk), t, tk) with an annual discount rate function r(t tk) > 1,
k ¼ 0,. . ., N, at arbitrary time tk ∈ R1 for arbitrary t ∈ R1, is defined by
1
dðrðt tk Þ; t; tk Þ ¼ , ð2:2:3aÞ
ð1 þ rðt tk ÞÞðttk Þ
and for equidistant knots tj ¼ j with rj ¼ r(tj) and tk ¼ 0, the abbreviation
1
dj rj ¼ d r tj ; tj ; 0 ¼ tj ð2:2:3bÞ
1 þ rj
is often used.
We see that in (3), $1 is discounted by the discount factor d(r, t, tk). We consider
in the following the more general form by considering a cash flow C and a
beginning value BV:
BVðC; rðt tk Þ; t; tk Þ ¼
Cdðr; t; tk Þ
C
: ð2:2:4Þ
1 þ r t tk ðttk Þ
Example 2.4 We choose N ¼ 4 in (1, 2) with a cash flow $3 in t ¼ tN ¼ 4. With

t0 ¼ 0 and r(t) ¼ r ¼ 5% in (3), we have for the beginning value BV with (4)
3.00
2.50
2.00
r = 0.5
r =0
1.50
r = -0.5
1.00
0.50
-6.00 -4.00 -2.00 0.00 2.00 4.00 6.00
Fig. 2.3 Discount factor ex post and ex ante
$2 $2
BVð$3; 2%; 2; 0Þ ¼ ¼ ¼ $1:567052:
ð1 þ rÞ4 ð1 þ 0:05Þ4
In Fig. 2.3, we assume N ¼ 10 and show the discount factor for the interest rates
r ¼ 0.05, r ¼ 0, and r ¼ 0.05 between the times t0 ¼ 5 (ex post) and t10 ¼ 5
(ex ante). We see that the behavior of the discount factors is different for positive
and negative discount factors.
Remark 2.2 From Eq. (2.1.1), we have with C ¼ EV after one time unit
C ¼ BV ð1 þ rÞ:
On the interval r ∈ (1, 0), we see that value is destroyed, i.e., C < BV, and for
r ¼ 1, we have complete loss, i.e., C ¼ 0.
The following lemma summarizes some fundamental properties about discount
factors:
Lemma 2.1 In (4) we have under the assumption C > 0:
(a) For fixed r ∈ R1 with r > 1 and t ∈ R1 with t > 0, BV(C, r, t, tk) is a
monotonically increasing linear function of C, i.e.,
BVðλC; r; t; tk Þ
ð2:2:5Þ
¼ λBVðC; r; t; tk Þ, λ ∈ R1 :
(5) says that by changing the cash flow by a fixed factor, the value at present is
multiplied by the same factor.
(b) For fixed C ∈ R1 and t ∈ R1 with t > 0, BV(C, r, t, tk) is a monotonically

decreasing function of r. The higher the interest, the less worth is the money at
present.
(c) For C ∈ R1 and for t ∈ R1, BV(C, r, t, tk) is for a fixed r ∈ R1:
• With r > 0 monotonically decreasing
• With r ¼ 0 constant
• With 1 < r < 0 monotonically increasing function of t
(d) The series of the discount factor
C
dn ¼ , n ¼ 1, 2, 3, . . .
ð1 þ rÞn
are:
• For r > 0, monotonically decreasing and converging with limit 0.

• For r ¼ 1, the series is constant with dn ¼ 1, n ¼ 1, 2, 3, . . .,
• For 1 < r < 0, the series dn is diverging for n! 1 .
Proof From (4), we have
1 1 1
¼ ,
ð1 þ rÞðttk Þ ð1 þ rÞt ð1 þ rÞtk
and by assuming r > 1, we have
1
> 0,
ð1 þ rÞtk
i.e., in order to show monotonicity, it is enough to consider
C
BVðC; r; t; 0Þ ¼ :
ð1 þ r Þt
The assertions a and b follow from the partial derivatives
∂BV 1
¼ > 0,
∂C ð1 þ r Þt
∂BV
¼ Ct ð1 þ rÞτ1 < 0:
∂r
The assertion c follows also from the partial derivative and the hypothesis that
the coupon is positive. We have to distinguish the following cases:
• For r > 0,
∂BV
¼ Cet ln ð1þrÞ
ð ln ð1 þ rÞÞ < 0:
∂t
• For r ¼ 0,
∂BV
¼ 0,
∂t
• For 1 < r < 0,
∂BV
¼ C et ln ð1þrÞ
ð ln ð1 þ rÞÞ > 0:
∂t
The assertion d follows from induction with respect to n. □

Lemma 2.1 discusses the monotonicity of the discount factors. We assumed
three independent variables, C, r, and t. In the following lemma, we change the
three variables simultaneously, and we see that there is no monotonicity.
Lemma 2.2 For 100C ¼ t (1 t 10) and C ¼ r, the function defined in (4) has a
global maximum for C ¼ 7.259173%, and we have
BVðC; C; C=100Þ ¼ 4:364739:
Proof By assumption, we have:
C C
BVðC; r; tÞ ¼ t ¼ :
ð1 þ rÞ ð1 þ CÞ100C
We use the product rule for the derivative
1
d
dBV 1 ð1 þ CÞ100C 1 dexpð100C ln ð1þCÞÞ
¼ 100C
þC ¼ 100C
þC
dC ð1 þ C Þ dC ð1 þ C Þ dC
1 d ð100C ln ð 1 þ C Þ Þ
¼ þ Cexpð100C ln ð1þCÞÞ
ð1 þ CÞ100C
dC

1 100C
¼ 1 þ C 100 ln ð1 þ C Þ þ :
ð1 þ CÞ100C 1þC
The condition
function values
2
first Derivative
BV
second derivative
1
0
1 2 3 4 5 6 7 8 9 10 11
-1
C
Fig. 2.4 Global maximum
∂BV
¼0
∂C
is the same as

1 C 100C
100 ln 1þ ¼ 0:
C 100 1þC
Figure 2.4 shows this function, and a numerical method calculates the values
stated in the lemma, which completes the proof. □
We investigate the behavior of the discount factors in more detail in Example 4.7
(Chap. 4).
2.3 Annuities
In this section, we consider multiple cash flows. We start with the following
definition:
Definition 2.2 An annuity is a finite set of level sequential cash flows at equidis-
tant knots (2.2.2). An ordinary annuity has a first cash flow one period from the
present, i.e., in the time point t1 ¼ 1. An annuity due has a first cash flow
immediately, i.e., at t0 ¼ 0. A perpetuity or a perpetual annuity is a set of level
never-ending sequential cash flows.
2.3 Annuities 13
Lemma 2.2 A closed formula for the beginning value BVor of an ordinary annuity
in the time span between t0 ¼ 0 and tN is, for 1 < r < 0 or r > 0,
!
C 1
BVor ¼ 1 , ð2:3:1aÞ
r ð1 þ rÞN
and for the ending value EVor we find
C
EVor ¼ ð1 þ rÞN 1 : ð2:3:1bÞ
r
For r ¼ 0, we have
BVor ¼ EVo ¼ N:
A closed formula for an annuity due for the beginning value BVdue in the time
span t0 ¼ 0 and tN is, for 1 < r < 0 or r > 0,
!
C 1
BVdue ¼ 1þr , ð2:3:2aÞ
r ð1 þ r ÞN
and for the ending value EVdue, we find
C
EVdue ¼ ð1 þ rÞNþ1 1 : ð2:3:2bÞ
r
For r ¼ 0, we have
BVdue ¼ N þ 1:
A closed formula for the value PBVor of perpetual ordinary annuity in t0 ¼ 0 is,
for 1 < r < 0 or r > 0,
C
PBVor ¼ : ð2:3:3aÞ
r
A closed formula for the value PBVdue of an perpetual annuity due in t0, t0 ¼ 0,
denoted by PBVdue, is, for 1 < r < 0 or r > 0,
Cð1 þ rÞ
PBVdue ¼ : ð2:3:3bÞ
r
Proof We use the closed formula of a geometric series. For details see
Appendix A. □
Remark 2.3 EV and BV are related by
BV
EV ¼ , ð2:3:4Þ
ð1 þ rÞN
and for N!1 and r > 0, we have
EV ¼ 0:
Example 2.5 For N ¼ 1 in (1a), we have

C 1 C 1þr1 C
BVor ¼ 1 ¼ ¼ :
r 1þr r 1þr 1þr
For N ¼ 1 in (2a), we have

C ð1 þ r Þ2 1
C 1 Cð2r þ r2 Þ C
BVdue ¼ 1þr ¼ ¼ ¼Cþ :
r 1þr rð1 þ rÞ rð1 þ rÞ 1þr
Example 2.6 With C ¼ $150,000 and r ¼ 3%, we have by (3a)
$150, 000
¼ $5, 000, 000,
3%
i.e., for an annual income of $150,000, the capital of $5,000,000 is needed.
The following lemmas decompose the balance at each point of time of a cash
flow into the cash flow and the accumulated interest rate.
Lemma 2.3 (Repayment of Mortgage) We assume that a BV and an interest r > 0

are given. The periodic payment of ordinary annuity is
r
Cor ¼ BV , ð2:3:5aÞ
1 ð1þr
1
ÞN
and for an annuity due, we have
r
Cdue ¼ BV : ð2:3:5bÞ
ð1 þ rÞ ð1þr1ÞNþ1
Starting with an initial value BV, we consider the iteration
C
Bnþ1 ¼ Bn þ : ð2:3:6Þ
ð1 þ rÞnþ1
2.3 Annuities 15
With B1 ¼ 1þr
C
and (6) with n ¼ 2,. . .,N, we have for an ordinary annuity
(1a)
BN ¼ Bord ¼ BV: ð2:3:7aÞ
With B0 ¼ C and (6) with n ¼ 1,. . .,N, we have for an annuity due (2a)
BN ¼ Bdue ¼ BV: ð2:3:7bÞ
We decompose the annuity by the part that is due to the interest rate in the last
period and the part which is due to the amortizing part
C ¼ r Bn þ ðC r Bn Þ:
Proof We consider the partial sum
X
n
C
Bn ¼ k
:
k¼1 ð1 þ rÞ
Then, for n ¼ N, we have (7a) based on (5) and Lemma 2.2. We consider the
partial sum
X
n
C
Bn ¼
k¼0 ð1 þ rÞk
with B0 ¼ C, and the proof (7b) follows like for the proof for (7a). □
Lemma 2.4 (Accumulation of Capital) We assume that an EV and an interest rate

r > 0 are given. The periodic payment of ordinary annuity is
r
Cor ¼ EV , ð2:3:8aÞ
ð1 þ r ÞN 1
and for an annuity due, we have
r
Cdue ¼ EV ð2:3:8bÞ
ð1 þ rÞNþ1 1þr
1
:
We consider the iteration
Enþ1 ¼ ð1 þ rÞnþ1 C þ En : ð2:3:9Þ
With E1 ¼ (1+r) C and (9) with n ¼ 2,. . .,N, we have for an ordinary annuity
(1b)
Table 2.1 Amortization schedule

Scheduled End of month
Beginning of month Mortgage principal mortgage
Month mortgage balance payment Interest repayment balance
1 100,000 742.50 677.08 65.41 99,934.59
2 99,934 742.50 676.64 65.86 99,868.73
⋮ ⋮ ⋮ ⋮ ⋮ ⋮
359 1470.05 742.50 14.88 727.54 737.50
360 737.50 742.50 4.99 737.50 0.000
Eor ¼ EN ¼ EV: ð2:3:10aÞ
With E0 ¼ C and (9) with n ¼ 1,. . .,N, we have for an annuity due in (2b)
Edue ¼ EN ¼ EV: ð2:3:10bÞ
We decompose the annuity by the part which is due to increase of the balance
minus the interest rate payment in last period:
C ¼ ð C þ r En Þ r En :
Proof We consider the partial sum
X
n
En ¼ ð1 þ rÞk C:
k¼1
Then, for n ¼ N, we have (10a) based on (5) Lemma 2.2. We consider the partial sum
X
n
En ¼ ð1 þ rÞk C:
k¼0
with E0 ¼ C. The proof (10b) follows like the proof for (10a). □
Example 2.7 We consider a fixed-rate mortgage such that the payments are equal.
We consider a mortgage of $100,000 with a mortgage rate of 8.125% over 10 years
with monthly payments. The investor pays off the mortgage completely in equal
installments. We have
rð1 þ rÞN
C ¼ BV ¼ ¼ $742:50:
ð1 þ rÞN 1
The amortization schedule is in Table 2.1.

The Flat Yield Curve Concept
3
3.1 The Description of a Straight Bond
The financial market consists of the credit market, the capital market, and the
money market. The bond market is part of the capital market. The financial industry
distinguishes traditional and alternative investments. Fixed income instruments are
traditional investments. We start with the following definitions.
Definition 3.1 A straight bond with price P will pay back the original investment
at its maturity date T and will pay a specified amount of interest on specific dates
periodically.
A straight bond is the most basic of debt investments. It is also known as a plain
vanilla or bullet bond. The cash flows illustrated in Fig. 1.1 are referring to a
straight bond.
Example 3.1 (Description of a Bond Universe) Most of the bonds in the Swiss
bond market are straight bonds.
Definition 3.2 The face value F of a bond is the amount repaid to the investor
when the bond matures. The face value is also called the par value of a bond or the
principal, stated, or maturity value of a bond.
Definition 3.3 Coupon C is a term used for each interest payment made to the bond
holder.
We distinguish between registered and unregistered bonds. A bearer bond is
unregistered and the investor is anonymous. Whoever physically holds the paper on
which the bond is issued owns the bond. Recovery of the value of a bearer bond in
the event of its loss, theft, or destruction is usually impossible. The collection of the
coupon is the task of the investor. Often, the bank collects the coupon payment on
behalf of the investor. If the issuer of the bond kept a record of the investor, we

18 3 The Flat Yield Curve Concept
F + CN
IP,P C1 C2 Ck CN-1
t0 = 0 t1 t2 tk t N-1
tN = T
Fig. 3.1 Cash flows
speak of a registered bond. The issuer of the bond sends the coupon payments to the
investor.
Figure 3.1 shows on the horizontal axis the specific dates and the corresponding
cash flows denoted with the coupons and the face value. Generally, a fixed income
instrument is a series of cash flows of coupons and a face value. A straight bond is
the starting point for studying fixed income instruments.
Definition 3.4 The time to maturity tm ¼ t tN is the remaining lifetime of

the bond.
Remark 3.1 In Fig. 3.1, we assume that t0 is the origin, i.e., t0 ¼ 0 on the time axes.
Moreover, in the following, we assume that tk, k ¼ 1,. . .,N are the times of the
analysis.
Definition 3.5 A zero coupon bond is a bond which does not pay interest before
the maturity date.
A straight bond can be considered as a series of zero coupon bonds. Bonds have
therefore a so-called linear structure.
Definition 3.6 The flat yield curve concept assumes that each coupon and the face
value of a specific bond are discounted by the same interest rate.
We consider an annual paying bond with N Coupons C and face value
F. Referring to knots (2.1.2), we specify N equidistant knots on the time axis with
corresponding time tk denote them
tk ¼ k, 0 k N:
We consider the price P of a bond that is valid at issuance:
X
N
C F
Pðt0 Þ ¼ Pð0Þ ¼ þ :
j¼1 ð1 þ rÞ j
ð1 þ rÞN
The price P of a bond that is valid just after the payment of a coupon is
3.1 The Description of a Straight Bond 19
X
N
C F
Pðtk Þ ¼ PðkÞ ¼ þ : ð3:1:1aÞ
j¼kþ1 ð1 þ rÞ
jk
ð1 þ rÞN
The formula is only valid at the day the coupon is paid. We consider the remaining
coupons of the bond at time tk
C
, j ¼ k þ 1, . . . , n:
ð1 þ rÞj
We extend to any time and to the period before the coupon the next coupon for the
coupon at time tk+j
C
tkþj t , t ∈ tkþj1 ; tkþj , j ¼ 1, . . . , N: ð3:1:1bÞ
ð1 þ r Þ
We proceed with the following definition:
Definition 3.7 (Invoice Price) A bond pricing with invoice price (IP) quotes the
price of a bond that includes the present values of all future cash flows incurring
including the interest accruing until the next coupon payment.
Remark 3.2 P and IP as a function depend on the variables r, C, F, tN ¼ N and the

time and the frequency of the coupon payments. In this book, we only consider
annual buying bonds, and therefore, the frequency is 1 and C, F are kept constant. In
the following, we consider one point in time. Therefore we suppress these
arguments.
Remark 3.3 The invoice price is also called the dirty or full price.
For k ¼ 0,. . .,N 1, we have with (1)
1 XN
C F
IPðtÞ ¼ tkþ1 t þ , t ∈ ½tk ; tkþ1 : ð3:1:2aÞ
ð1 þ rÞ j¼kþ1 ð1 þ rÞ
j
ð1 þ rÞN
By using the closed formula, we have

! !
1 C 1 F
IPðtÞ ¼ tkþ1 t 1þr þ ,t ∈ ½tk ;tkþ1 :
ð1 þ r Þ r ð1 þ rÞN k1
ð1 þ rÞN k1
ð3:1:2bÞ
Then we have, for t to tk+1,
IP ðtk Þ IPþ ðtk Þ ¼ C, k ¼ 1, . . . , N 1:

price (P) =100

Invoice accrued interest clean price
+ today price
Coupon (C) Coupon (C) Coupon (C) Coupon (C) Face (F) + tim
− Coupon (C) e
Fig. 3.2 The invoice and the clean price
In Fig. 3.2, we observe a zigzag line which represents the invoice price of a bond
as introduced in Definition 3.7. We distinguish between days where a coupon is
paid and days where no coupon is paid. We require the following definition.
Definition 3.8 (Accrued Interest) Accrued interest is an accounting method for

measuring the interest rate that is either payable or receivable and has been
recognized but not yet paid or received. It occurs as a result of the difference in
timing of cash flows and the measurement of these cash flows. If we assume
periodic coupon payments C, then, for k ¼ 1, . . . . , N 1, the accrued interest
AIk is defined by
AIk ¼ ðt tk1 Þ C, t ∈ ½tk1 ; tk Þ: ð3:1:3aÞ
Remark 3.4 For k ¼ 1, . . . , N 1, we have no AI, but the coupon is paid.
Remark 3.5 By referring to Fig. 3.2, we introduce
ακ ¼ 1 ðt tk1 Þ C, k ¼ 0, . . . , N 1,
and
AIκ ¼ ð1 ακ ÞC, k ¼ 0, . . . , N 1, t ∈ ½tk1 ; tk Þ ð3:1:3bÞ
is the same as (3a).

As accrued interest is calculated daily, we have to change from the unit year to
the unit days, and we obtain a step function (Fig. 3.3).
If the month is calculated with 30 days, the accrued interest is horizontal and
stays the same. In February, the accrued interest changes vertically, and accrued
interested is cumulated.
The International Capital Market Association (ICMA) recommends in its Rule
251 that the number of days accrued should be calculated as the difference between
Fig. 3.3 Accrued interest

with 30/360
C
360
30.1.xx 31.1.xx 1.2.xx Time [days]
Table 3.1 Calculation of Number of days

the accrued interest
20.08.xx 30.08.xx 11
September 30
October 30
November 30
December 30
01.1.xx 25.01.xx 24
155
the date of the last payment inclusive (or the date from which the coupon is due, for
a new issue) up until, but not including, the value date of the transaction.
Example 3.2 (Day Counting) We consider a bond that pays a coupon at 20.08.xx,
and we assume that the value date of the transaction is 25.01.xx. Assuming that the
month is calculating with 30 days, Table 3.1 gives the number of days.
Definition 3.9 (Clean Price) The price of a coupon bond not including any
accrued interest is called clean price and is denoted by P.
Remark 3.6 The flat or simple price is the same as clean price.
We find that
Clean price¼Invoice Price-Accrued Interest,
i.e., by (3),
* +
1 C 1 F
PðtÞ ¼ tk t ð1þrÞ þ ð1αÞC,t∈ ½k1;k:
ð1 þ r Þ r ð1 þ r Þ Ntk
ð1 þ rÞNtk
The price of the bond is based on the evaluation of all cash flows. In mathemati-
cal terms expressed, this means that the bond has a linear structure.
For continuous compounding, we have
X
N
Pð0Þ ¼ Cejr þ FeTr : ð3:1:4Þ
j¼1
If we spread the coupon over the time t ∈ [tk1, tk], i.e., if we consider continuous
compounding by starting an equal distant sample of the interval tj to tj+1
(see Appendix E), then
X
M C ð
tjþ1
C
lim M
¼ dt
M!1
m¼1 ð1 þ rÞ
ððtj þMm ÞÞ ð1 þ r Þt
tj
and we have
N1 ð
tjþ1 tðN
X C F C F
Pð0Þ ¼ t dt þ ¼ t dt þ :
j¼1 ð1 þ rÞ ð1 þ rÞm ð1 þ rÞ ð1 þ r Þm
tj 0
We see that by continuous compounding we have no accrued interest, i.e., the

invoice price is equal to the flat price.
Theorem 3.1 We consider the recursion
FþC
P1 ¼ ð3:1:5aÞ
1þr
and
Pn þ C
Pnþ1 ¼ , 1 n N 1: ð3:1:5bÞ
1þr
At the times knot defined by (2.1.1), the following holds with P1 ¼ F ¼ 100 and
n ¼ 1, 2, 3, . . . . , N 1:
(a) If r < C, then Pn+1 > Pn.

(b) If r ¼ C, then Pn ¼ 100.
(c) And if r > C, then Pn+1 < Pn.
Proof For (a) and (b), this follows as the closed formula for Pn is

C 1 F
Pn ¼ 1 n þ , 1 n N:
r ð1 þ r Þ ð1 þ rÞn
For the difference, we then have

!
C 1 F C 1 F
Pnþ1 Pn ¼ 1 þ 1 þ
r ð1 þ rÞnþ1 ð1 þ rÞnþ1 r ð1 þ r Þn ð1 þ rÞn

1 C 1
¼ F 1 :
ð1 þ r Þn r 1þr
Then, for Cr < 1 and Cr > 1, the sequence is increasing and decreasing, respec-
tively, and for C ¼ r, the difference vanishes. Therefore, the assertion (c) is
shown. □
Example 3.3 We consider a face value F ¼ 100. Then, with C ¼ 2% and r ¼ 4%,
we have
P10 ¼ 124:012, P20 ¼ 159:556,
and, with C ¼ 4% and r ¼ 2%, we have
P10 ¼ 78:100, P20 ¼ 51:405:
Definition 3.10 If the bond price is P ¼ 100, then the bond price is said to be at par.
If the bond price P is less than 100, then we have a discount bond. If the bond price
P is over 100, then we have a premium bond.
Corollary 3.1 We consider an annual paying bond with price P, yields r, and
Coupon C with C > 0, C ∈ R1. At the times of knots as defined in (2.2.1), the
following holds for n ¼ 1, 2, 3, . . . . ,N 1:
(a) If 0 < r < C, then Pn < 100.

(b) If r ¼ C, then Pn ¼100.
(c) And if r > C or 1 < r < 0 (negative interest), then Pn > 100.
Proof We consider the recursion (5) and we prove the corollary by induction with
respect to n. For n ¼ 1, we distinguish the following cases:
FþC FþC
P1 ¼ < ¼ 100,
1þr 1þC
FþC FþC
P1 ¼ ¼ ¼ 100,
1þr 1þC
FþC FþC
P1 ¼ > ¼ 100:
1þr 1þC
Assuming that the assertion is true for n, we consider n ¼ 1, 2, 3, . . . . , N 1 as
Pn þ C
Pnþ1 ¼
1þr
(a) Case Pn < 100: as F ¼ 100, this follows by Pn < F by (5)
FþC
Pnþ1 < < 100:
1þr
(b) Case Pn ¼ 100: as F ¼ 100, this follows by Pn ¼ F by (5)
FþC
Pnþ1 ¼ ¼ 100:
1þr
(c) Case Pn > 100: as F¼100, we have Pn > F by (5) and
FþC
Pnþ1 > > 100:
1þr
□
Example 3.4 A treasury bill (or for short T-bill) is a zero coupon money market
instrument.
3.2 Yield Measures
As depicted in Fig. 3.4, we consider a bond portfolio with cash flow at fixed
equidistant time points tk ¼ k, k ¼ 1, . . . . , N ¼ T.
IP,P C1 Ck CN - 1 F+C N
t
t0 = 0 t 1 tk tN-1 tN = T
Fig. 3.4 Equidistant knots over unit intervals
3.2 Yield Measures 25
Fig. 3.5 The maturity profile Bond
j
C
j,k
Time
k T
n
Definition 3.11 (Constituents of a Bond Portfolio) For the price Pj of the bond j,
1 j n, with time of maturities 1 Tj Tn and with cash flows Cj,k and face
values Fj, we have the price of a bond as a function of r as
X
Tj-1
Cj, k CTj þ FTj
Pj ðrÞ ¼ þ , 8rj ∈ R1 : ð3:2:1Þ
k¼0 ð1 þ rÞ
k
ð1 þ rÞTj
Without loss of generality, we now assume that the bond is sorted in ascending
order, i.e., 1 Tj Tj + 1 Tn , 1 j j + 1 n. Figure 3.5 shows the maturity
profile of the portfolio.
Definition 3.12 (Yield to Maturity) Assuming that the price of the bond is given,
the yield to maturity (YTM) rj of a bond with price Pj is the solution of (1)
X Tj1
Cj, k CTj þ FTj
P j rj ¼ k þ T : ð3:2:2Þ
k¼1 1 þ rj 1 þ rj j
In the following, the assumptions are that:
• It is assumed that all coupons are paid, i.e., there are no defaults.
• The investor holds the bond until maturity.
• We are looking forward, i.e., we consider the cash flow in the future.
• The yield to maturity is the solution of this equation written down here, which
says that the cash flows in the future discounted to today equal to the price paid
in the market. The principle is based on an arbitrage relationship, i.e., a
condition which avoids a situation with a profit without risk.
• It is not clear how yield to maturity is added for different bond.
• It is not clear whether the solution is unique.
For the last two points, there is current research being conducted by [1, 2].
We assume that a portfolio with n bonds is ordered with decreasing times to
maturity. We assume that in this portfolio there are Nj of bond j, and n is the number
of bonds that have a cash flow in time tk ¼ k, 1 k Tj. Then the portfolio value Po
is
!
X
n X
n X
Tj
Nj Cj, k Nj Fj
PoðrÞ ¼ N j P j ðr Þ ¼ þ : ð3:2:3Þ
j¼1 j¼1 k¼1 ð1 þ rÞk ð1 þ r ÞT j
A solution of (3) is called the true yield or the internal rate of return. The
internal rate of return is a solution of a transcendental equation. In Sect. 4.4, we
examine different methods for approximating solutions of (3).
Remark 3.7 In this section and the following section, we consider the flat rate
concept. This, however, does not mean that the yield curve is flat.
In the following, we consider a portfolio consisting of only one bond with a
given price. We denote the yield to maturity with YTM.
Example 3.5 (YTM of a Zero Coupon Bond) The price of zero coupon bond is
F
P¼ , t ∈ R1 :
ð1 þ rÞt
By solving with respect to r, we find

rffiffiffiffiffiffiffiffiffiffiffi
t F
YTM ¼ 1:
P
Definition 3.13 The yield to maturity of a zero coupon bond is called the spot
rate.
Example 3.6 (YTM in the Last Period) As can be seen in the proof of Theorem
2.1, the price of a bond in the last period is
FþC
P¼ ,
1þr
and therefore we have
FþC
YTM ¼ 1:
P
Example 3.7 We consider 3 bonds that have a coupon of 3% with YTMs 2%, 3%,
or 4% and time to maturity of 3 years. In Table 3.2 the cash flow analysis can be
seen.
The second column (t ¼ 0) of Table 3.2 shows the price of the different bonds. In
this example, the YTD is given. In practice, the bond is given, and the yield to
maturity has to be computed. We illustrate the general principle that if the YTD is
below the coupon, then the price is above the par value (premium bond). If the YTD
is equal to the coupon, then we have a par bond. And that if YTD is beyond the
coupon, the price is below the par value (discount bond).
Example 3.8 We want to determine whether the yield of a semiannual 6% 15-year

bond with face value of $100 selling at $84.25 is 7.2%, 7.6%, or 7.8%. We compute
the present value PVC of the cash flows of the cash by using the formula
1 1
ð1þ2r Þ
n
C
PVC ¼ ,
2 r
and the PVF of the face value F
1
PVF ¼ F n :
1 þ 2r
The price P of the bond is the
P ¼ PVC þ PVF :
Table 3.3 below shows the computed values.

We see that for the price $84.25, we have YTM ¼ 7.8%. With YTD ¼ 6.0%,
(1) yields P ¼ 100%.
Table 3.2 Pricing of r (%) 1 2 3 Total

a bond
2 2.9412 2.8835 97.0592 102.8839
3 2.9126 2.8278 94.2596 100.0000
4 2.8846 2.7737 91.5666 97.2249
Table 3.3 Different yield YTM Cash flow Face value PV of the bond
of maturity
0.072 54.4913 34.6105 89.1017
0.074 53.8191 33.6231 87.4422
0.078 52.5118 31.7346 84.2465
Definition 3.14 (Current Yield) The current yield or direct yield of a bond j is
defined by
Cj
DYdir, j ¼ : ð3:2:4Þ
Pj
Theorem 3.2 We consider an annual paying bond with price P, yield to maturity r,
and Coupon C. Then, at the times of knots defined in (2.1.2), the following holds:
(a) If P > 100, then C > DY > YTD.

(b) If P ¼ 100, then C ¼ DY ¼ YTD.
(c) If P < 100, then C < DY < YTD.
Proof As in Theorem 3.1, we consider
FþC
P1 ¼ ,
1þr
Pn þ C
Pnþ1 ¼ , 1 n N 1:
1þr
Then we have P ¼ PN, and we proof the theorem by induction. For N ¼ 1, we
have
FþC
P1 ¼ ,
1þr
and thus
FþC
1 ¼ r ¼ YTM,
P1
and hence
FþC
1 ¼ r ¼ YTM,
P1
i.e.,
F
1 þ DY ¼ YTM: ð3:2:5Þ
P1
For a discount bond, the assertion follows from PF1 > 1, for a par bond PF1 ¼ 1, and
for a premium bond PF1 < 1. We assume that the assertion is true for n and consider
Pn þ C
Pnþ1 ¼ :
1þr
We find by (3) that
Pn
1 þ DY ¼ YTM:
Pnþ1
The assertion now follows from Theorem 3.1. □
Remark 3.8 The direct yield of a zero coupon bond is 0, which makes little
sense.
Definition 3.15 Par yield or par rate denotes the coupon rate for which the price of
a bond is equal to its nominal value (or par value).
In the following, we illustrate Theorem 3.2 and the concept of IRR.
Example 3.9 (Discussion of the Cash Flows for a Bond with Two Cash Flows)
We consider a bond with 2 years to maturity and investigate the reinvested rate. By
(3.1.1a), we have
C FþC
P¼ þ :
1 þ r ð1 þ rÞ2
By using the discount factor (2.2.3b)
1
d¼ , ð3:2:6Þ
1þr
we find that
P ¼ C d þ ðF þ CÞ d2 :
Hence,
0 ¼ ðF þ CÞ d2 þ C d P:
The solutions are

qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
C ðCÞ2 þ 4ðF þ CÞP
d1=2 ¼
2ð F þ C Þ
We see in Fig. 3.6 that the business relevant solutions are in the neighborhood
of 1.
2.00
1.50
1.00
0.50
C=0
Price Function
C>0
0.00
-2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 C< 0
-0.50
-1.00
-1.50
Discount Factor
Fig. 3.6 Different solutions
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
C ðCÞ2 þ 4ðF þ CÞ P
d1 ¼ ,
2ðF þ CÞ
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
C þ ðCÞ2 þ 4ðF þ CÞ P
d2 ¼ :
2ð F þ C Þ
We note that d1 is not business relevant. With P ¼ F (par), we have
2C 2F
d1 ¼ ¼ 1,
2ðF þ CÞ
F
d2 ¼ :
FþC
Thus,
1 FþC C
r¼ 1¼ 1¼ :
d2 F F
We conclude that if C < 0, then r < 0, if C ¼ 0, then r ¼ 0, and, finally, if C > 0,
then r > 0 (see Figs. 3.7 and 3.8). Thus, the property b in Theorem 3.2 is extended to
the real numbers.
We proceed by assuming that the rate after time 1 is fixed and invest the return.
We call this return modified internal rate of return. We consider two cases.
Fig. 3.7 Cash outflow

P
C F t[years]
0 1 2
Fig. 3.8 Cash inflow

P C
F t[years]
0 1 2
(a) C > 0 (outflow)
The cash flow is discounted to the time t ¼ 0 and
C FþC
P¼ þ ,
1 þ r0 ð1 þ rÞ2
and thus
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
FþC
r¼ 1: ð3:2:7Þ
P 1þr C
0
(b) C < 0 (inflow)
The cash flow is discounted to the time t ¼ 2
ð1 þ rÞ2 P ¼ ð1 þ r0 Þ C þ ðF þ CÞ,
i.e., with positive coefficient, we have
ð1 þ rÞ2 P ð1 þ r0 Þ C ¼ F þ C,
and then
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
F þ C þ ð1 þ r0 ÞC
r¼ 1: ð3:2:8Þ
P
Table 3.4 Modified rate Cash flow Cash flow

of return
Spot 5 5
0 0.0513150 0.0513167
0.01 0.0510412 0.0515803
0.02 0.0507729 0.0518439
0.03 0.0505101 0.0521076
0.04 0.0502525 0.0523714
0.05 0.0500000 0.0526352
0.06 0.0497524 0.0528992
0.07 0.0495097 0.0531632
0.08 0.0492716 0.0534272
0.09 0.0490380 0.0536914
0.1 0.0488088 0.0539556
In the numerical example, we chose C ¼ 5% and C ¼ 5% with an internal rate

of r ¼ 5% and r ¼ 5%.
In Columns 2 and 3 of Table 3.4, we see the modified internal rate. We see that
the modified internal is applicable for negative rates. For positive spot rates, the
modified internal rate of return is equal to the par rate if the spot rate is 5%.
3.3 Duration and Convexity
Frederik Macaulay originally began in 1938 to investigate the impact of interest

rates on the movements of bonds. For instance, solely looking at the time to
maturity does suffice for this purpose. A zero coupon bond and a bond with a
coupon with the same time to maturity might have a different behavior under
different rate scenarios.
The basic idea of duration is the amalgamation of different characteristics of a
straight bond. It helps to manage the risk of bonds and bond portfolios. There are
different duration concepts. We start by the duration concept that is based on three
independent variables, namely, the time to maturity, the coupon and the price or
equivalently the time to maturity, and the coupon and the yield to maturity.
Definition 3.16 (Macaulay Duration) The Macaulay duration DMac i

ðr Þ of a bond
with N Coupons C, face value F, the fraction α between coupon payments, and an
annual yield to maturity r measures the average life of bond j and is defined as the
weighted average of the time to the next cash flows, namely,
P
N
ðj 1 þ αÞð1þrCÞj1þα þ ðN 1 þ αÞ F
ð1þrÞN1þα
j j¼1
DMac ðr Þ ¼ : ð3:3:1Þ
P
N
C
ð1þrÞj1þα
þ F
ð1þrÞN1þα
j¼1
3.3 Duration and Convexity 33
In the nominator, there is the time weighted by the discounted cash flows, and in
the denominator, we have the price of the bond.
The crucial property of the Macaulay duration is as follows. At each time, one
can evaluate the value of a bond. If yields are changing, as of today, the value of the
bond is changing due to the changing of the reinvestment values of the coupons and
the price of the bond changes. Under some assumptions, for the Macaulay duration,
these effects are compensating. For a zero bond, the Macaulay duration is equal to
the number of years to maturity. This can be seen algebraically from the formula
(1), that is we have
Lemma 3.1 The Macaulay duration of a zero coupon

i
DMac ðrÞ ¼ N 1 þ α:
Remark 3.9 A closed formula for the Macaulay duration is found in

Appendix G.
Remark 3.10 Furthermore, we see that the unit of Macaulay duration is time.
In the following, we want to illustrate the Macaulay duration. The following
formula is the value at issuance of the bond:
X
N
C F X
N
C F
k k þ N N k k þ N N
k¼1 1 þ rj 1 þ rj k¼1 1 þ rj 1 þ rj
j
Dmac rj ¼ ¼ : ð3:3:2Þ
XN
C F P rj
k þ N
k¼1 1 þ rj 1 þ rj
The formula is only applicable to times when there is a coupon payment.

Furthermore, we see that the unit of Macaulay duration is time.
Remark 3.11 The Macaulay duration is invariant under the multiplication by a

discount factor and thus (2) is the same as
PN
k C kN þ NF
k¼1 ð1þ rj Þ
Dmac rj ¼ N
j
:
P
kN þ F
C
k
k¼1 ð1þ rj Þ
Example 3.10 (Continuation of Example 3.7) We consider 3 bonds with 3 years

to maturity each and with 3% coupons and yields 2, 3, and 4. Table 3.1 shows the
denominator in (2) and the following Table 3.5 shows the nominator in (2).
Table 3.5 Calculating the Macaulay duration

Time-weighted Time-weighted Time-weighted Time-weighted
price coupons coupon coupons + face
r (%) 0 1 2 3
2 299.8858 2.9412 5.7670 291.1776
3 291.3470 2.9126 5.6556 282.7788
4 283.1318 2.8846 5.5473 274.6999
Fig. 3.9 Macaulay duration
me
now Duraon (Equilibrium)
By dividing the numerator by the denominator, the Macaulay durations are
2.9148
2.9135
2.9121.
Remark 3.12 The Macaulay duration can be calculated in two ways. Either by
evaluating the series, or there is a closed formula (see Appendix G).
We note that the Macaulay duration is less than the time to maturity.
In Fig. 3.9, we have a graphical illustration of the Macaulay duration. We see the
fulcrum or the equilibrium of the bond, i.e., 50% of the weight is on either side. We
see that the scale is at balance. The black area is the discount value of the cash
flows.
The following Theorem 3.3 discusses the Macaulay duration as a function of the
coupon, the yield of maturity, and the time to maturity. We examine the behavior of
the Macaulay duration with respect to these variables. We first discuss the domain
of the definition of the variable.
(a) Discount factors
C
dn ¼ , n ¼ 1, 2, 3, . . .
ð1 þ rÞn
are defined for r < 1 and r > 1. The discount factors are not defined for
r ¼ 1. In finance, only the domain r > 1 is of interest. As can be seen from
Lemma 2.1, the behavior of the discount factors is different dependent for the
domain of the definition for the interest rate.
(b) C is a real variable with C 0, C ∈ R1.

(c) As
Dmac ¼ 1 ð3:3:3aÞ
for T ¼ 1, independently of the coupons C and the interest rate r, we examine
T > 1: ð3:3:3bÞ
Theorem 3.3 (Coupon and Yield to Maturity) Following Definition 3.1, we

consider a straight bond with Coupon C, face value F, yield to maturity r, and
time to maturity T. We assume T > 1. Following Remark 3.11 with
X
N
1 XN
1
AðrÞ ¼ j jN
, B ð rÞ ¼ jN
, ð3:3:4aÞ
j¼1 ð1 þ r Þ j¼1 ð1 þ rÞ
the Macaulay duration can be expressed as
AðrÞ C þ T F
DMac ðC; r; T Þ ¼ : ð3:3:4bÞ
BðrÞ C þ F
We discuss the variables C and r of Dmac by keeping the remaining two of the
three variables C, r, and T in Dmac fix. We consider the following cases:
(a) (Coupon): for C1 < C2 and
BðrÞ < AðrÞ T, ð3:3:5Þ
we have
Dmac ðC2 ; r; TÞ < Dmac ðC1 ; r; TÞ,
i.e., if the coupon rates increases or decreases, resp., then the Macaulay duration of
a bond decreases or increases, respectively.
(b) (Yield to maturity): for r > 1, C > 0, r1 < r2, and
∂A ∂B
< Dmac , ð3:3:6Þ
∂r ∂r
we have
Dmac ðC; r2 ; TÞ < Dmac ðC; r1 ; TÞ,
i.e., as market yields increase or decrease, respectively, the Macaulay duration of a

bond decreases or increases, respectively.
Remark 3.13 In case a, we do not need the assumption C > 0, but in case b it is
required because the coupon is dropping by division.
Proof The derivative of (4) yields

∂DMac BðrÞðAðrÞ C þ FÞ AðrÞBðrÞ C þ TF BðrÞ F AðrÞ T F
¼ ¼ :
∂C ðBðrÞ C þ FÞ 2
ðBðrÞ C þ FÞ2
The condition ∂D∂CMac < 0 is the same as
BðrÞ AðrÞ T < 0:
By assumption (5), it follows that Dmac as a function of C is monotonically

decreasing. We consider the second case b (yield to maturity) and consider
GðC; rÞ ¼ AðrÞ C þ T F, ð3:3:7Þ
HðC; rÞ ¼ BðrÞ C þ F,
and have by (4a) that
GðC; rÞ AðrÞ C þ T F
Dmac ðC; r; tÞ ¼ ¼ :
HðC; rÞ BðrÞ C þ F
The derivative with respect to r then yields
∂AðrÞ
∂Dmac ðC; r; tÞ C ∂r
ðBðrÞ C þ FÞ C ∂B∂rðrÞ ðAðrÞ C þ T FÞ
¼ :
∂r ðBðrÞ C þ FÞ2
This is the same as

∂AðrÞ
ðHðC; rÞÞ C ∂B∂rðrÞ ðG ðC; ; rÞÞ
¼ :
∂r ðH ðC; rÞÞ2
By (4) and (7), we have
GðC; rÞ ¼ Dmac ðC; rÞ HðC; rÞ,
and thus
∂AðrÞ
ðHðC; rÞÞ C ∂B∂rðrÞ ðDmac ðC; rÞ HðC; rÞÞ
¼ :
∂r ðH ðC; rÞÞ2
As we have assumed C > O, and as the price H(C, r) is positive, the condition
∂DMac
∂r
< 0 is the same as
∂A ∂B
Dmac < 0,
∂r ∂r
and, by hypothesis (6), the assertion of the theorem is shown. □
Theorem 3.4 (Time to Maturity) Following Definition 3.1, we consider a straight

bond with Coupon C, face value F, yield to maturity r, and time to maturity
T. Following Definition 3.16 we consider the Macaulay duration expressed as
P
T
C
jð1þr Þj
þ T ð1þr
F
ÞT
j¼1
DMac ðC; r; T Þ ¼
P
T
C
ð1þrÞ j
þ ð1þFrÞT :
j¼1
Assuming C > 0 and r > 0, we have for T!1
rþ1
DMac ðrÞ ¼ : ð3:3:8Þ
r
We consider three cases for the time of maturities as variable:
1. C ¼ 0, r > 1: the Macaulay duration as a function of the time to maturity is
linear, and more specifically we have
Dmac ¼ T:
2a. 0 < C < r: the Macaulay duration as function of the time maturity is with
1 þ 1r
a¼F ð3:3:9Þ
1 Fr
C
monotonically increasing on the interval T ∈ [0, a] with
rþ1
Dmac ðaÞ ¼ :
r
On the interval T ∈ [a, 1), the duration-time relationship is first strictly
monotonically increasing and then strictly monotonically decreasing converging
to (8). The values for the Macaulay duration for T ∈ [a, T0) are repeated for
T ∈ [T0, 1). T0 is the solution of the fixed point equation
f ð TÞ ¼ T
with
γ ln ð1 þ rÞð1 þ rÞT F þ ðβ þ FÞ αð1 þ rÞT þ ðβ þ FÞ2

f ðTÞ ¼ ,
β ln ð1 þ rÞð1 þ rÞT ðβ þ FÞ
where
C
β¼
r
and

C 1
γ¼ 1þ :
r r
2b. 0 < r C: the yield time to maturity is monotonically increasing with (8) as
the limit when T ! 1.
3. 1 < r < 0 and C > 0: the yield time to maturity is monotonically increasing
in t when T ! 1, and more specifically
1 þ 1r
lim ðDmac ðC; r; TÞ TÞ ¼ :
T! 1 1 Cr
Proof As we discuss the time of maturity T, we use the closed formula (see
Appendix G)
h i
C 1 þ 1r ð1 þ rÞT 1 T þ FTr
Dmac ðC; r; TÞ ¼
ð3:3:10Þ
C ð1 þ rÞT 1 þ Fr
and consider
h i
C 1 þ 1r ð1 þ rÞT 1 T þ FTr
lim Dmac ðC; r; TÞ ¼ lim
:
T!1 T!1
As r > 0 and C > 0 is assumed, we differentiate twice, and we find by the

L’Hopital’s rule that
h i
C 1 þ 1r ð1 þ rÞT 1 CT þ FTr
lim
T!1

C 1 þ 1r ð1 þ rÞT ln ð1 þ rÞ C þ Fr
¼ lim
T!1
C ð1 þ rÞT ln ð1 þ rÞ

C 1 þ 1r ð1 þ rÞT ðln ð1 þ rÞÞ2 1

¼ lim
¼1þ
T!1 T
C ð1 þ rÞ ðln ð1 þ rÞÞ 2 r
and thus we find the assertion (8) that
1
lim Dmac ðC; r; TÞ ¼ 1 þ :
T!1 r
We proceed to the three cases. The assertion 1 follows from (9), and we proceed
to assertion 2a. From
h i
C 1 þ 1r ð1 þ rÞT 1 T þ FTr 1

¼1þ ,
T
C ð1 þ rÞ 1 þ Fr r
we conclude
C Tr þ F T r2 ¼ ðr þ 1ÞFr ð3:3:11Þ
and
F T r2 Fr2 C Tr Fr ¼ 0,
and thus
FTr Fr CT F ¼ 0,
i.e.,
FTr CT ¼ Fr þ F:
We find for the solution T ¼ a that
Fr þ F
a¼ ,
Fr C
and as a consequence we have (8). Then (10) is the same as
h i
C
r 1 þ 1r ð1 þ rÞT 1 þ FT
Dmac ðC; r; TÞ ¼
T
r ð1 þ rÞ 1 þ F:
C
With
C
β¼
r
and

C 1
γ¼ 1þ
r r
by Identification with (4), we have the closed form solution
Bðr; TÞ ¼ ð1 þ rÞT 1, ð3:3:12aÞ
γBðr; TÞ βT þ FT
Dmac ðC; r; TÞ ¼ :
βBðr; TÞ þ F
We differentiate with respect to T and obtain

∂Dmac ðC; r; TÞ γ ∂B∂T

ðr;TÞ
β þ F ðβBðr; TÞ þ FÞ β ∂B∂T
ðr;TÞ
ðγBðr; TÞ βT þ FT Þ
¼ :
∂T ðβBðrÞ C þ FÞ2
The condition
∂Dmac ðC; r; TÞ
¼0
∂T
is the same as

∂Bðr;TÞ ∂Bðr;TÞ
γ β þ F ðβBðr;TÞ þ FÞβ ðγBðr;TÞ βT þ FT Þ ¼ 0, ð3:3:13Þ
∂T ∂T
and hence
∂Bðr; TÞ ∂Bðr; TÞ
γ βBðr; TÞ þ γ F þ ðβ þ FÞ βBðr; TÞ þ ðβ þ FÞ F
∂T ∂T
β γBðr; TÞ þ β Tðβ þ FÞ¼ 0:
∂T ∂T
By solving for T, we find
γ F þ ðβ þ FÞ βBðr; TÞ þ ðβ þ FÞ F β Tðβ þ FÞ ¼ 0
∂T ∂T
and
γ ∂B∂T
ðr;TÞ
F þ ðβ þ FÞ βBðr; TÞ þ ðβ þ FÞ F
T¼ :
β ∂B∂T
ðr;TÞ
ðβ þ FÞ
We replace the function B(r,T) and its derivative by using (12a) we have
∂Bðr; TÞ ∂ ∂ ln ðð1þrÞT Þ ∂ T ln ð1þrÞ

¼ ð1 þ rÞT ¼ e ¼ e ¼ eT ln ð1þrÞ ln ð1 þ rÞ
∂T ∂T ∂T ∂T
¼ ln ð1 þ rÞð1 þ rÞT , ð3:3:14aÞ
∂B2 ðr; TÞ
¼ ðln ð1 þ rÞÞ2 ð1 þ rÞT : ð3:3:14bÞ
∂T2
We have r > 0 and T > 1
∂Bðr; TÞ ∂B2 ðr; TÞ

Bðr; TÞ > 0, > 0, > 0,
∂T ∂T2
we see that the for β > 1, we have a potential solution which is
γ ln ð1 þ rÞð1 þ rÞT F þ ðβ þ FÞ β Bðr; TÞ þ ðβ þ FÞ F

T¼
andtaking (12), (13), and (14b) into consideration, we see that we have the differ-
ence (13) and the derivation of (13) consisting of two strictly monotonically
increasing functions of T > 1 and fixed r. Thus there exists a unique solution of
the equation. By replacing (12) we have

γ ln ð1 þ rÞð1 þ rÞT F þ ðβ þ FÞ β ð1 þ rÞT 1 þ ðβ þ FÞ F

T¼ :
We then find
γ ln ð1 þ rÞð1 þ rÞT F þ ðβ þ FÞ βð1 þ rÞT þ ðβ þ FÞ2

T¼ :
We proceed with case 2b. With (11), we consider

C 1
T þ FT ¼ F 1 þ ,
r r
and hence

C 1 1
þF¼F 1þ :
r r T
We consider the distance from the asymptotic value (8)

1 1 C
f ð TÞ ¼ F 1 þ þ F
r T r
for Cr 1, and we see that, for T 1, we have f(T) > 0 and decreasing for T!1
and we conclude the assertion (2).
We proceed with case 3. (10) is the same as
h i
Dmac ðC; r; TÞ ¼
,
and hence
h i
Dmac ðC; r; TÞ ¼
þ
:
C ð1 þ rÞ 1 þ Fr C ð1 þ rÞT 1 þ Fr
T
For 1 < r < 0, we get

C 1 þ 1r 1 þ 1r
lim Dmac ðC; r; TÞ ¼ þT¼ þ T:
T!1 C þ Fr 1 FCr
As we have shown assertion 3 of the theorem, the proof of the theorem is

completed. □
Example 3.11 We consider a straight bond with a constant to maturity of T ¼ 2

years. We have
P
2
j C
ð1þrÞj
þ 2ð1þr
F
Þ2
j¼1
Dmac ¼
P
2
j C
ð1þrÞj
þ ð1þr
F
Þ2
:
j¼1
which is the same as
Cð1 þ rÞ þ 2ðF þ CÞ Cð1 þ rÞ þ 2 C þ 2 F

Dmac ¼ ¼ :
Cð1 þ rÞ þ F þ C Cð1 þ rÞ þ C þ F
We proceed by calculating the derivative with respect to C, namely,

∂Dmac ð1 þ r þ 2ÞðCð1 þ rÞ þ C þ FÞ Cð1 þ rÞ þ 2C þ 2F ð1 þ rÞ þ 1
¼ :
∂C ðCð1 þ rÞ þ F þ CÞ2
With
AðrÞ ¼ r þ 3 and BðrÞ ¼ r þ 2, ð3:3:15Þ
we have
∂DMac AðrÞðBðrÞC þ FÞ BðrÞðAðrÞC þ 2FÞ AðrÞ 2BðrÞ

¼ ¼ :
∂C ðCð1 þ rÞ þ F þ CÞ 2
ðCð1 þ rÞ þ F þ CÞ2
The condition (5)
∂DMac
< 0
∂C
is the same as
AðrÞ 2 BðrÞ < 0:
thus
r þ 3 < 2r þ 4:
We see that this inequality is satisfied for r > 1.

We now illustrate case 2 and calculate the derivative with respect to r. By (15),
we have
∂A
¼1
∂r
and
∂B
¼ 1,
∂r
and thus, the condition (6) is
1 < Dmac :
As Dmac > 1, this inequality is satisfied. We see that the values for the Macaulay
duration are increasing for decreasing coupon and yield.
Example 3.12 We illustrate Theorem 3.3 and consider a straight bond with a
constant to maturity T ¼ 7 years. In Table 3.6.we have some sample value.
In Figs. 3.10 and 3.11, we look at the interest rate, coupon as continuous
variables, and discrete values for the coupon and interest value. We see that
Figs. 3.10 and 3.11 show the decreasing values of the Macaulay duration as a
function of increasing coupons and yield. For investing in discount factors, we
could come to the conjecture that this behavior of the Macaulay duration as function
of coupon and yield is different. However, as the discount factor is in the denomi-
nator and the nominator of the ratio that defines the Macaulay duration, we cannot
conclude from the discount factor to the overall behavior of the Macaulay duration.
Example 3.13 In Fig. 3.12 we illustrate Theorem 3.4 for a discount bond (case 2a).
We consider a straight bond with a coupon of 1% and choose some yields that
exceed the coupon. If the coupon is zero, we have a linear relationship between
Table 3.6 Sample values Coupon

for Macaulay duration
Interest 4% 2%
0.04 6.242137 6.569376
0.02 6.294218 6.601431
Duration (Time to Maturity 7 years)

7.50
7.00
C=0
6.50
Mac Duration C=0.2
6.00 C=0.4
5.50 C=0.6
C=0.8
5.00
-0.100 -0.050 0.000 0.050 0.100 0.150
Interest rate
Fig. 3.10 Interest as a variable

Duration (Time to Maturity 7 years)

7.50
7.00
r=-0.06
6.50
r=-0.03
Mac Duration
r=0.0
6.00
r=0.03
r=0.06
5.50 r=0.09
5.00
0.00 0.02 0.04 0.06 0.08 0.10
Coupon
Fig. 3.11 Coupon as variable
Time To Maturity (Asymtotic)

30
25
20 r = 0.01
r=0.05
15
r= 0.1
10 r=0.15
r=0.2
5
0
0 5 10 15 20 25 30
Fig. 3.12 Time to maturity as variable
duration and time to maturity. In Theorem 3.4, we derived the equation for the time
for the largest Macaulay duration and the domain for the time to maturity in which
the Macaulay duration assumes the same value twice. In Fig. 3.12 and the described
Theorem 3.4, we see that for increasing yield the Macaulay duration comes faster to
the asymptotic value.
Theorem 3.5 (Hedging Property of the Macaulay Duration) If the investor

chooses the time horizon equal to the Macaulay duration, then the portfolio is not
sensitive to parallel shifts of the yield curve up to second order.
Proof We look at the price of the bond at time t with coupon payment in tk,
1 k N,
X
N
C F
Pðr; tÞ ¼ ðtk tÞ
þ :
k¼1 ð1 þ r Þ ð1 þ rÞðtN tÞ
and by the Taylor series (see Appendix C) in r we request
∂Pðr; tÞ
¼ 0: ð3:3:16Þ
∂r
In order to be insensitive for a shift, we consider the discount factor as
1
dðr; tÞ ¼ ,
ð1 þ rÞðtk tÞ
and the derivatives with respect to r are
∂ 1 tk t
¼ ,
∂r ð1 þ rÞ ð tk t Þ
ð1 þ rÞðtk t1Þ
2
∂ 1 ðtk t 1Þðtk tÞ
¼ ,
∂r2 ð1 þ rÞðtk tÞ ð1 þ rÞðtk t2Þ
i.e., we have
∂ 1 tk t
ð1 þ rÞ ¼ , ð3:3:17aÞ
∂r ð1 þ rÞðtk tÞ ð1 þ rÞðtk t Þ
2
∂ 1 ðtk t 1Þðtk t Þ
ð1 þ rÞ2 ¼ : ð3:3:17bÞ
∂r2 ð1 þ rÞðtk tÞ ð1 þ rÞðtk t Þ
From (16), we have
1 ∂Pðr; tÞ
¼0
ð1 þ rÞ ∂r
and
∂ XN
∂ C ∂ F
Pðr; tÞ ¼ þ :
∂r k¼1
∂r ð1 þ rÞ ðtk tÞ ∂r ð1 þ rÞðtN tÞ
We have by (17a)
1 ∂ X
N
Cðtk tÞ FðtN tÞ
Pðr; tÞ ¼ þ ¼ 0:
ð1 þ rÞ ∂r k¼1 ð1 þ r Þ ðtk tÞ
ð1 þ rÞðtN tÞ
At tk we have a loss and profit for the price and at time of maturity we have a
profit and loss reinvesting the coupon if the interest rate shifts upward and down-
ward. By solving with respect to t, we get the time when the profit equals the loss
and the bond position stays the same.
P
N
Ctk
ðtk tÞ þ F tN
k¼1 ð1þrÞ ð1þrÞðtN tÞ
Dmac ¼ ,
PN
C
ðtk tÞ þ F
k¼1 ð1þrÞ ð1þrÞðtN tÞ
which is the same as
P
N
Ctk
ð1þrÞtk
þ ð1þr
Ftk
ÞtN
k¼1
Dmac ¼ :
PN
C
ð1þrÞtk
þ ð1þrF ÞtN
k¼1
□
As we introduce in (3.2.2) and (3.2.3), the transition from a single bond to a bond
portfolio, we proceed with the following definition for the Macaulay duration (see
also Fig. 3.5):
Definition 3.17 The Macaulay duration DMac Po

ðrÞ of a portfolio P consisting of n
bonds Bj, 1 j n, is at issue, or just after a coupon payment of Nj units, as function
of r defined by
P
n P
Tj
N C N F
j j
k ð1þr Þk
þ Tj ð1þrj ÞjTj
j¼1 k¼1
Po
Dmac ðrÞ ¼ : ð3:3:18Þ
P
n P
Tj
Nj Cj N F
ð1þrÞk
þ ð1þrj ÞjTj
j¼1 k¼1
Theorem 3.6 The Macaulay duration of a portfolio is linear in the constituents

Po
of the portfolio, or, more precisely, the Macaulay duration of a portfolio Dmac ðrÞas a
function of a yield r (or, more mathematically expressed, with r as an independent
j
variable), is the weighted average of the durations of the constituents Dmac ðrÞ of the
portfolio, i.e., we have
X
n
Po
Dmac ðrÞ ¼ wj ðrÞ Dmac
j
ðrÞ: ð3:3:19Þ
j¼1
The weights are
Nj Pj ðrÞ
wj ðrÞ ¼ ,
PoðrÞ
where Nj is the quantity and Pj is the price of the constituents j. Po is the value of the
portfolio as a function of j.
Proof By using the notation (3.2.3) for the portfolio value, the Macaulay duration
of the portfolio as define in (18) becomes
!
X
n X
Tj
Nj Cj, k Nj Fj XT1
N1 C1, k N1 F1
k þ Tj Tj k þ T1
j¼1 k¼0 ð 1 þ r Þ k
ð 1 þ rÞ ð1 þ r Þk
ð1 þ r ÞT 1
Po
Dmac ðrÞ ¼ ¼ k¼0
PoðrÞ PoðrÞ
XTn
Nn Cn, k Nn Fn
k þ TN
k¼0 ð 1 þ r Þ k
ð 1 þ rÞTn
þ: . . . þ :
PoðrÞ
By multiplying with the Price Pi(r), we have
P
T1
C
N1 P1 ðrÞ 1, k
tk ð1þr Þk
þ tT1 ð1þr
F1
ÞT1
k¼0
Po
Dmac ðrÞ ¼ þ ::...
PoðrÞ P1 ðrÞ
T
Pn C n, k
Nn Pn ðrÞ tk ð1þr Þ k þ tTn
Fn
ð1þrÞTn
k¼0
þ :
PoðrÞ Pn ðrÞ
We consider the weights
Nj Pj ðrÞ
w j ðr Þ ¼ , 1 j n,
PoðrÞ
and find (19).

As the true internal rate of return is laborious to calculate, the following
approximation is often used, namely,
X
n
Po
Dmac ðYTM1 ; : . . . ; YTMn Þ ¼ j
wj Dmac YTMj ð3:3:20Þ
j¼1
with

Nj Pj YTMj
wj ¼ , 1 j n,
PoðYTMÞ
where
PoðYTMÞ ¼ N1 P1 ðYTM1 Þ þ . . . : : þ Nn Pn ðYTMn Þ:
Remark 3.14 The approximation of the Macaulay duration of a portfolio by

(20) to the true Macaulay duration (18) is investigated in the next section.
We call (20) the yield to maturity approach, and we proceed with the internal
rate of return approach in Sect. 3.4. The spot rate approach is left the Chap. 4.
We continue with the concept of Modified duration. Modified duration is a
leverage factor that gives an indication of the price volatility of a bond.
j
Definition 3.18 The continuous modified duration Dmod ðrÞ of a bond j with clean
price P ¼ P (r) is defined by
j
∂Pj ðrÞ
j ∂r
Dmod ðr Þ ¼ ∂ , ð3:3:21Þ
P ðrÞ
j
Po
and the Modified duration Dmod ðrÞ of a bond portfolio Po with clean prices
P ¼ P (r) is defined by
j
∂PoðrÞ
∂r
Po
DMod ðrÞ ¼ :
PoðrÞ
Remark 3.15 As the accrued interest r is independent of the modified duration of

the invoice price and the clean price, the nominator in (21) is same, but in the
denominator of (21) it is the invoice price.
Although the interpretation between modified duration and Macaulay duration is
different, the connection between the two concepts is surprisingly simple:
Lemma 3.2 We have
Dmac ðrÞ ¼ ð1 þ rÞ Dmod ðrÞ: ð3:3:22Þ

Proof We consider the discount factor
1
dðr; kÞ ¼ :
ð1 þ rÞk
By differentiation, we have
∂dðr; kÞ k
ð1 þ rÞ ¼ ¼ k dðr; kÞ,
∂r ð1 þ rÞk
and the linearity yields
ð1 þ rÞDmod
i
ðrÞ ¼ Dmac
i
ðrÞ:
Remark 3.16 If the Macaulay duration is known, the modified duration can be
calculated by (22). Another way would be the approximation of the denominator. In
numerical analysis, it is well known that the calculation of derivative presents
several problems. In the case of calculating the modified duration, the evaluation
of the closed form problem is much more laborious than the approximation of the
derivative by, e.g., central differences (see Appendix D and [3])
Pj ðr þ ΔrÞ Pj ðr ΔrÞ
ΔPj ¼ :
2Δr
Thus, we proceed with the approximation of the derivative and the discrete
version.
j
Definition 3.19 The discrete modified duration DDMod for a bond j of the modified
duration is
ΔPj ðrÞ
j Δr
DDMod ðr; ΔrÞ ¼ ,
P ðrÞ
j
Po
and the discrete version DDmod for a portfolio of the modified duration is
ΔPoðrÞ
Δr
Po
DDMod ðr; ΔrÞ ¼ :
PoðrÞ
Thus, we have
j
ΔPj ðrÞ ¼ DDmod ðrÞPj ðrÞΔr ð3:3:23Þ
for the price change ΔPj. For instance, the price change ΔPj for 100 bps is
j
ΔPj ðrÞ ¼ DDmod ðrÞPðrÞ 0:01:
j
The absolute duration ADmod ðrÞ is defined by
j j
ADmod ðrÞ ¼ Dmod ðrÞPðrÞ:
Definition 3.20 (Basis Points) A basis point is defined by 1 bps ¼ 0.01%.
Example 3.14 Let us assume that we have a bond with a price of 90.46. We
assume a yield shift of 15 bps with corresponding prices 89.79 and 91.14. The
modified duration is
91:14 89:79
¼ 4:9435:
2 90:46∗ 0:0015
∗
Lemma 3.3 Theorem 3.4 is also valid for the continuous and the discrete version
of the modified duration
X
n
j
Po
Dmod ðr Þ ¼ wj ðrÞ Dmod ðr Þ ð3:3:24aÞ
j¼1
and
X
n
j
Po
DDmod ðrÞ ¼ wj DDmod ðrÞ: ð3:3:24bÞ
j¼1
Proof (24a) follows from:
(a) (19) and multiplying by (22).

(b) The linearity of the derivative: with (3.1.3), we consider the price of the
portfolio Po(r) and for the assertion (24a) derived with respect to r.
∂Po ∂P1 ∂Pn

¼ N1 þ . . . : þ Nn :
∂r ∂r ∂r
For (24b), we consider (3.1.3) and the proof follows as in the proof of
Theorem 3.6. □
Although duration gives the impression that the price yield relationship is linear,
this is wrong. Convexity is a figure that accounts for the degree of the nonlinearity
of the price yield relationship. In Fig. 3.13, we see the price yield relationship of a
straight. Bond 2 has higher convexity than bond 1. We see that higher convexity is
Bond 1
price
Bond 2
P0 Error of linear approximaon
P1
yield
r0 r1
Fig. 3.13 The convexity of a bond
desirable for the investor, but convexities can only be compared when the Macaulay
durations of the considered instruments are the same.
As we have seen, the duration allows the investor to approximate the price of the
bonds P(r). The approximation of the price change by Δr ¼ r r0 is
∂PðrÞ
Pðr þ ΔrÞ ¼ PðrÞ þ Δr þ O Δ2
∂r ð3:3:25Þ
¼ PðrÞ DMod Pðr; tÞΔr þ O Δ2 :
Definition 3.21 The continuous convexity of a bond j is defined by

2
∂ P j ðrÞ
2
∂ r
Co j ðrÞ ¼ ð3:3:26aÞ
P ðrÞ
j
and the continuous convexity of a portfolio Po is defined by

2
∂ PPo ðrÞ
2
∂ r
Co ðrÞ ¼
PO
: ð3:3:26bÞ
P ðr Þ
Po
For a straight bond, we see from (17) that convexity is positive. The calculation
of (26) by closed formulae requests an intricate expression (Appendix H). A
discrete version DCoj(r) can be based on the approximation (Appendix D) of the
second derivative in (26):
ΔPð2Þj ¼ P j ðr þ ΔrÞ 2P j ðrÞ þ P j ðr ΔrÞ:

j
Definition 3.22 The discrete version DComod of the convexity of a bond is
ΔPð2Þj ðr;tÞ
j ðΔrÞ2
DComod ðr; ΔrÞ ¼ :
pj ðrÞ
Po
and the discrete version DComod of the convexity of a portfolio Po is
ΔPð2ÞPo ðr;tÞ
ðΔrÞ2
DCoPmod
0
ðr; ΔrÞ ¼ :
pPo ðrÞ
We consider the Taylor expansion including the second derivative
∂Pðr; tÞ
2
∂ Pðr; tÞ
Pðr þ Δr; tÞ ¼ Pðr; tÞ þ Δr þ ðΔrÞ2 þ O Δ3 :
∂r 2
∂ r
Hence, by (25) and (26a),

Pðr þ Δr; tÞ ¼ Pðr; tÞ Dmod Pðr; tÞΔr þ Co Pðr; tÞðΔrÞ2 þ O Δ3 ,
and the discrete version is

Pðr þ Δr; tÞ ¼ Pðr; tÞ DDmod Pðr; tÞΔr þ DCo Pðr; tÞðΔrÞ2 þ O Δ3 :
Example 3.15 We consider a semiannual bond with Coupon C ¼ 5%, yield ¼ 5%,
and time to maturity T ¼ 25 years. The discrete duration DDmod with
DDmod ¼ 14:18783597
and
DCo ¼ 141:7403786:
We compute
Papp1 ðr þ ΔÞ ¼ PðrÞ DMod Pðr; tÞΔr
and
Papp2 ðr þ Δr; tÞ ¼ Pðr; tÞ DDmod Pðr; tÞΔr þ DCo Pðr; tÞðΔrÞ2 :
The Figs. 3.14 and 3.15 shows the price difference of the real bond by the
approximation by duration and convexity. In the following, we show the difference
of the exact price versus the approximation Papp1 using the duration and the exact
price versus the approximation Papp2 using the duration and the convexity.
0.14
0.12
0.10
0.08 Approximation Duration
0.06
Approximation Duration
0.04 and Convextiy
0.02
0.00
0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
-0.02
Fig. 3.14 30 bps deviation
20.00
15.00
10.00 Appproximation Duration
Approximation Duration and

5.00 Convextiy
0.00
0.00 0.02 0.04 0.06 0.08 0.10
-5.00
Fig. 3.15 300 bps deviation
Lemma 3.4 For the convexity CoPo of a portfolio, we have
X
n
CoPo ðrÞ ¼ wj ðrÞ Co j ðrÞ:
j¼1
Proof With (3) we consider the price of the portfolio PoV(r) and derive twice with
respect to r
2 2 2
∂ PoV ∂ P1 ∂ Pn
2
¼ N1 2
þ . . . . . . þ Nn 2
,
∂ r ∂ r ∂ r
and the proof follows as in the proof of Theorem 3.6. □
3.4 The Approximation of the Internal Rate of Return 55
Remark 3.17 In currency world terms, colloquially, the term convexity means that
the price goes up more up that it goes down [4]. In the bond world, it is the same, the
investor gains more that he loses for comparable convexities.
Remark 3.18 Convexity for callable bond is negative for declining interest rate
(see Sect. 4.4).
Remark 3.19 There are two approaches for calculating the modified duration and
the convexity of a straight bond. In most software, the discrete versions in Defini-
tion 3.19 and Definition 3.22 are used. These are approximations. In Appendix G,
there is an analytic expression for the Macaulay duration. This formula can be
conveniently used for calculating the modified duration (see (22)). Appendix H is
an analytic expression for the convexity. As can be seen, the expressions become
quite intricate. They are called closed formulae because they do not contain sums.
3.4 The Approximation of the Internal Rate of Return
Based on (3.2.3), we start with the net asset value NAV of a portfolio defined by
!
X
n X
Tj
Nj Cj Nj Fj
NAVðrÞ ¼ PB0 þ
j¼1 k¼1 ð1 þ rÞk ð1 þ rÞTj
!
X
n X n XTj
Nj Cj Nj Fj
¼ N j P j rj þ , ð3:4:1aÞ
j¼1 j¼1 k¼1 ð1 þ rÞ
k
ð1 þ rÞTj
for r > 1. With the abbreviations

Pj ¼ Pj rj , j ¼ 1, . . . :, n,
and
X
Tj
Cj Fj
Pj ðrÞ ¼ þ ,
k¼1 ð1 þ r Þ k
ð1 þ rÞTj
we have
X
n X
n
NAVðrÞ ¼ Nj Pj Nj Pj ðrÞ: ð3:4:1bÞ
j¼1 j¼1
A solution IR of (1), i.e., a real number IR ∈ R1 that satisfies

NAVðIRÞ ¼ 0,
is called an internal rate of return of the portfolio and (1) is then called the
equation of the internal rate of return equation.
Remark 3.20 In [1], it is shown that (1) has in general multiple solutions.
However, in practical situations, there exists only one unique business relevant
solution. Thus, in this section, we assume that (1) has at least one real solution IR
with
∂ NAVðIRÞ
6¼ 0
∂ IR
and by considering
NAVðIRÞ ¼ 0
we can assume without loss of generality that
∂ NAVðIRÞ
> 0,
∂ IR
i.e., NAV(r) is locally monotonically increasing as seen in Fig. 3.16.
Example 3.16 We consider a portfolio of two zero bonds with prices
F
P 1 ðr 1 Þ ¼ ,
1 þ r1
F
P2 ðr2 Þ ¼ ,
ð1 þ r2 Þ2
and choose r1 ¼ 0.05, r2 ¼ 0.025, and F ¼ 1. The condition NAV(r) ¼ 0 leads to

solving the quadratic equation for the IRR and with the chosen values we find
Fig. 3.16 A realization of a NAV(r)

zero of the IRR equation 1.00
0.50
0.00
-0.60 -0.40 -0.20 0.00 0.20 0.40 0.60
-0.50
-1.00
-1.50
-2.00
-2.50
IR1 ¼ 0:03335918, IR2 ¼ 1:508203:
Figure 3.16 shows the NAV(r) function in the neighborhood of IR1. IR2 is not
considered in (1) as the discount factor is negative (see also [1]).
3.4.1 The Direct Yield of a Portfolio
We consider a bond portfolio with n bonds that have the yield to maturities YTMs
r1, . . . ,rj, . . . ,rn with prices P1, . . . ,Pj, . . . ,Pn and each position consists of N1, . . . ,
Nj, . . . ,Nn units. For the solution IR, we propose the approximations
X
n
rnom ¼ w j rj , ð3:4:2aÞ
j¼1
where
Nj
wj ¼ , ð3:4:2bÞ
P
n
Ni
i¼1
and
X
n
rlin ¼ ^ j rj ,
w ð3:4:3aÞ
j¼1
where
Nj Pj
^j ¼
w : ð3:4:3bÞ
P
n
Ni Pi
i¼1
Following Definition 3.14, we also consider the direct yield rdir of a bond
portfolio by denoting by Cj, 1 j n, the coupons of the bonds with the prices
Pj, 1 j n,
N1 C1 þ N2 C2 þ : . . . þ Nn Cn
rdir ¼ : ð3:4:4Þ
N1 P1 þ N2 P2 þ : . . . þ Nn Pn
Lemma 3.5 (Linearity of the Direct Yield) If we consider a portfolio of n bonds

(see Definition 3.11) with coupons Cj, 1 j n with Nj, 1 j n units, then the
direct yield is linear, i.e., the direct yield of a portfolio is the market price weighted
direct yield of the individual bonds of the portfolio.
Proof By (3b) and (4), we have by using the definition (3.2.4)
N1 C1 N2 C2 Nn Cn
rdir ¼ þ n þ :...... þ n
X
n X X
Ni Pi Ni Pi Ni Pi
i¼1 i¼1 i¼1
N1 P1 N1 C1 N2 P2 N2 C2 Nn Pn Nn Cn
¼ n þ n þ :... þ n
X X X
Ni Pi N1 P1 Ni Pi N2 P2 Ni Pi Nn Pn
i¼1 i¼1 i¼1
N1 C1 N2 C2 Nn Cn X
n
^1
¼w ^2
þw þ : : . . . þ w^ n ¼ wj rdir, j :
N1 P1 N2 P2 Nn Pn j¼1
□
In the following, lemma assumes a flat yield curve, i.e., the YTM is the same for
all bonds in a specific bond universe. The flat yield concept introduced in Definition
3.6, however, refers to a specific bond. Different discount factors are in general
applied to different bonds. The assumption of the following lemma is thus more
restrictive that the flat yield concept. The solution IR of (1) is the equal to the YTM.
Lemma 3.6 (More than the Flat Yield Concept) We consider (1) and assume a
flat yield curve, i.e., every bond portfolio with n bonds (see Definition 3.11) satisfies
with the same yield to maturity, i.e.,
YTM ¼ rj ð3:4:5Þ
with Nj, 1 j n units. Then we have
IR ¼ YTM, ð3:4:6Þ
i.e.,
NAVðIRÞ ¼ NAVðYTMÞ ¼ 0:
Proof We use (1)

!
X
n X n XTj
Nj Cj Nj Fj
NAVðrÞ ¼ Nj Pj rj þ :
j¼1 j¼1 k¼1 ð1 þ rÞ
k
ð1 þ rÞTj
By using (5), we have

!
X
n X
n X
Tj
Nj Cj Nj Fj
NAVðrÞ ¼ Nj Pj ðYTMÞ þ ,
j¼1 j¼1 k¼1 ð1 þ r Þk ð1 þ rÞTj
thus YTM is a solution of (1) and the lemma is thus shown. □

In the following, we discuss the approximations (2), (3), and (4) of the solution
IR of (1). The following lemma shows an easy situation where the weights of
(3b) are reducing to (2b).
Lemma 3.7 We consider (1) and assume that the portfolio consists of n par bonds
(see Definition 3.15) with YTMs rj with Nj, 1 j n units that mature in 1 year. It
follows that rnom and rlin are a solution of (1)
IR ¼ rnom , IR ¼ rlin ,
NAVðrnom Þ ¼ 0, NAVðrlin Þ ¼ 0:
Proof For a bond with 1 year to run, we have
Fj þ Cj
P rj ¼ :
1 þ rj
We use the assumptions Pj ¼ 1, Fj ¼ Pj with Cj ¼ rj, and consider the equation

(1) for the IRR

X
n Xn
Nj Cj þ Fj Xn Xn
Nj rj þ 1
NAVðrÞ ¼ Nj ¼ Nj :
j¼1 j¼1
1þr j¼1 j¼1
1þr
Thus, by solving (1b), we have
X
n X
n
ð1 þ r Þ Nj ¼ Nj rj þ 1 ,
j¼1 j¼1
and hence
X
n X
n
r Nj ¼ Nj rj :
j¼1 j¼1
By solving for r, we find (2), and as Pj ¼ 1, we have (3). □

The following Lemma 3.8 is a first generalization of Lemma 3.7. We assume a
credit portfolio, i.e., a portfolio with different par yields with the same time to
maturity.
Lemma 3.8 (Same Time to Maturity) We consider (1) and assume that the bonds
have the same time to maturity T ¼ 1, 2, 3,. . ., i.e., Tj ¼ T, 1 j n and distinguish
two cases.
(a) (par bonds) The n bond are all par bonds, i.e., the coupon is equal to the
YTM, i.e., Cj ¼ rj. Then (2) yields a solution of (1), i.e., rnom ¼ IR with
NAVðIRÞ ¼ NAVðrnom Þ ¼ 0, ð3:4:7aÞ
and (3) yields a solution of (1), i.e., rlin ¼ IR and
NAVðIRÞ ¼ NAVðrlin Þ ¼ 0: ð3:4:7bÞ
(b) (par bonds except one bond) The bonds are par bonds except one bond, i.e.,
there exist a m, 1 m n such that
C1 ¼ r1 , . . . , Cm1 ¼ rm1 , Cm 6¼ rm , Cmþ1 ¼ rmþ1 , . . . , Cn ¼ rn : ð3:4:8Þ
We find that the direct yield satisfies the equation
X
n Xn
Nj Cj
Nm Pm þ Ni ¼ 0: ð3:4:9Þ
j¼1
r
i¼1
i6¼m
For the approximation of rdir, we have
NAVðrdir Þ ¼ Nm R1m , ð3:4:10aÞ
where
Fm Pm
R1m ¼ R1 ðPm ; Fm ; rdir ; TÞ ¼ ð3:4:10bÞ
ð1 þ rdir ÞT
with
Nj
^j ¼
w ð3:4:11aÞ
P
n
Nm Pm þ Ni
i¼1
i6¼m
and
Nm Pm
w^ m ¼ : ð3:4:11bÞ
Pn
Nm Pm þ Ni
i¼1
i6¼m
In (3), we find that the direct yield approximation rdir is related to rlin by
R2 ðCm ; Fm ; rm ; Pm Þ
rdir ¼ rlin þ , ð3:4:11cÞ
Pn
Nm Pm þ Ni
i¼1
i6¼m
where
Cm rm Fm
R2m ¼ R2 ðCm ; Fm ; rm ; rm ; TÞ ¼ Nm : ð3:4:11dÞ
ð1 þ rm ÞT
For the approximation properties of the error terms, we are assuming rdir > 0 for
T!1, which gives
Rmi ! 0, i ¼ 1, 2, ð3:4:12aÞ
and for rm ! Cm
Rmi ! 0, i ¼ 1, 2: ð3:4:12bÞ
Proof We consider (1) with Tj ¼ T and apply the closed formula (A1.1) of
Appendix A for 1 j m

Cj 1 ð1þr
1
Þ T Fj
P j ðr Þ ¼ þ : ð3:4:13Þ
r ð1 þ rÞT
We substitute in (1b)
0
1
X
n X
n Nj Cj 1 ð1þr
1
Þ T Nj Fj A
NAVðrÞ ¼ Nj Pj @ þ :
j¼1 j¼1
r ð1 þ rÞT
Thus,
" #
Xn n
X
Nj Cj 1 Nj Cj
NAVðrÞ ¼ Nj Pj Nj Fj : ð3:4:14Þ
j¼1
r ð1 þ rÞT j¼1 r
We start with case (a). By assumption, we have Pj ¼ Fj ¼ 1 and rj ¼ Cj, and

hence
" #
X
n Xn
N j rj 1 X
n Xn
Nj rj
NAVðrÞ ¼ Nj Nj :
j¼1 j¼1
r ð1 þ rÞT j¼1 j¼1
r
By solving the first two parts of the sum and the expression in the parentheses of
this equation for r, we find
X
n X
n
r Nj Nj rj ¼ 0,
j¼1 j¼1
i.e.,
NAVðIRRÞ ¼ NAVðrnom Þ ¼ NAVðrlin Þ ¼ 0:
We proceed with case (b) and focus on the assertion formulated in (8). From
(13), we have for j ¼ m
!
1
Cm 1
ð1 þ rm ÞT Fm
Pm ¼ þ :
rm ð1 þ rm ÞT
This is the same as
1
Cm ¼ rm Pm þ ðCm Fm rm Þ: ð3:4:15Þ
ð1 þ r m ÞT
By extracting the index m, we have, with (14), Pj ¼ Fj ¼ 1 for j 6¼ m, and
n
Nm Cm X Nj Cj
NAVðrÞ ¼ Nm Pm þ Nj
r r
j¼0
j6¼m
2 3
6
1 6 Nm Cm Xn
Nj Cj 77
6 Nm Fm þ Nj 7:
ð1 þ r ÞT 4 r r 5
j¼0
j6¼m
By adding and subtracting the price with the units on the right-hand side, this is
the same as
n
Nm Cm X Nj Cj
NAVðrÞ ¼ Nm Pm þ Nj
r r
j¼0
j6¼m
2 3
n
1 6 6 Nm Cm X Nj Cj 7
7
T6
N P
m m N P
m m þ N F
m m þ Nj 7:
ð1 þ r Þ 4 r r 5
j¼0
j6¼m
ð3:4:16Þ
We neglect the difference Nm Fm Nm Pm of the right-hand side of the equation

and consider the equation by using the assumption that, for j 6¼ m, we have Pj ¼ Fj ¼ 1
and
n
Nm Cm X Nj Cj
NAVapp ðrÞ ¼ Nm Pm þ Nj
r r
j¼0
j6¼m
2 3
6 n
X 7
1 6 Nm Cm Nj Cj 7
T6 Nm Pm þ Nj 7: ð3:4:17Þ
ð1 þ r Þ 4 r r 5
j¼0
j6¼m
We see that
NAVapp ðrÞ ¼ 0
is the same as
X
n
r Nm Pm Nm Cm þ r Nj Nj Cj ¼ 0,
j¼0
j6¼m
i.e., the direct yield
P
n
Nj Cj
j¼0
rdir ¼ ð3:4:18Þ
P
n
Nm Pm þ Ni
i¼1
i6¼m
satisfies (7) and (15). Furthermore, we have by (14)
Fm Pm
NAVðrÞ NAVapp ðrÞ ¼ Nm ,
ð1 þ rÞT
and thus
Fm Pm
NAVðrdir Þ ¼ Nm :
ð1 þ rdir ÞT
We have shown (8) and we proceed to the relation of rlin and rdir. By using the
assumption (6) of the lemma together with (13) and (16), we have
P
n
Nj rj þ Nm Pm rm þ ð1þr1 T ðCm Fm rm Þ
mÞ
j¼0
j6¼m
rdir ¼ :
P
n
Nm Pm þ Ni
i¼1
i6¼m
Hence, with
Cm rm Fm
R2m ¼ R2 ðCm ; Fm ; rm ; TÞ ¼ Nm ,
ð1 þ r m ÞT
we have (9)
R2 ðCm ; Fm ; rm ; Pm Þ
rdir ¼ rlin þ :
Pn
Nm Pm þ Ni
i¼1
i6¼m
The approximation properties (10) follow from case (a) and from the explicit
expression for the error term. □
Remark 3.21 There is only a minor difference between case (a) and (b). In (a), we
assume that all bonds are par bonds, whereas in (b) we assume that all bonds are par
except one.
In the following example, we consider a portfolio with three bonds. Applying the
above lemma, we see that the IRR reduces to the YTM of a bond of the portfolio.
Example 3.17 [Lemma 3.6 Case (a)] We consider a portfolio that consists of
3 units of different par bonds with face value Fj ¼ F, j ¼ 1, 2, 3, i.e.,
C1 ¼ r1 , C2 ¼ r2 , C3 ¼ r3 ð3:4:19aÞ
with the same time to maturity and with the yield to maturities
r1 ¼ r2 α, r3 ¼ r2 þ α, α ∈ R1 : ð3:4:19bÞ
We evaluate the assumption of the example by (1a) and find first by the par
assumption that
X
3
Pj rj ¼ 3P2 ðr2 Þ: ð3:4:20aÞ
j¼1
Furthermore, we have by (19) for 1 j n

C1 C2 α
j
¼ ,
ð1 þ r Þ ð1 þ r Þj
C3 C2 þ α
j
¼ :
ð1 þ r Þ ð1 þ rÞj
For the portfolio P with
PðrÞ ¼ P1 ðrÞ þ P2 ðrÞ þ P3 ðrÞ,
we have
X
n
3C2 3F
3PðrÞ ¼ þ : ð3:4:20bÞ
j¼1 ð1 þ rÞj ð1 þ r Þn
Consequently, we have by (1a) and (20)
P2 ðr2 Þ ¼ PðrÞ: ð3:4:21Þ
Then, we have by (19b)
IR ¼ r2 :
By evaluation of (2), we have
1
wj ¼ , j ¼ 1, 2, 3, . . . ,
3
and thus
X
n
rj
rnom ¼ :
j¼1
3
By using (19b), we have
rnom ¼ r2 ,
and hence
IR ¼ rnom :
As we assume par bonds, we find with the evaluation of (3)
IR ¼ rlin :
The following example illustrates Lemma 3.7.

Example 3.18 (Lemma 3.7 [Case (a) and (b)] with Two Bonds of Same Time
of Maturity) We consider two bonds with Tj ¼ T ¼ 2, j ¼ 1, 2. The price of the
first bond is
X
2
C1 F1
P1 ð r Þ ¼ þ
j¼1 ð1 þ r Þ j
ð1 þ r Þ2
and is par, i.e., r ¼ C1. We choose F1 ¼ 1 and C1 ¼ 8%. The price of the second
bond is
X
2
C2 F2
P2 ðrÞ ¼ þ :
j¼1 ð1 þ rÞj ð1 þ rÞ2
We choose F2 ¼ 1 and a different value for the coupon C2. In addition, we use
the price P2 such that YTM ¼ 0.08. We consider the bond portfolio
PðrÞ ¼ P1 ðrÞ þ P2 ðrÞ:
We look at the different approximations of the IRR. As both the yields to

maturity are
rk ¼ 0:08, k ¼ 1, 2, ð3:4:22aÞ
we have
IR ¼ rnom ¼ rlin ¼ 0:08: ð3:4:22bÞ
Comparing rnom and rlin, the numerical value shows that the direct yield only
approximates the IR. As the time of maturity is short, the approximation of the
direct yield is rather bad as it does not reflect time value and assume time to
maturity infinity (compare Theorem 3.7). In Table 3.7, we show the error if
substituting the direct yield instead of IR in (1), i.e. R21 .
For the cash flow C ¼ 8%, we expand the above equation (22b) with
Table 3.7 Approximation C2 NAV(dir), R12 R22

error of the yield to
0.00000000 13.11224095 6.85871056
maturity
2.00000000 9.65281093 5.14403292
4.00000000 6.32190018 3.42935528
6.00000000 3.10775779 1.71467764
8.00000000 0.00000000 0.00000000
10.00000000 3.01058057 1.71467764
12.00000000 5.93217499 3.42935528
14.00000000 8.77209282 5.14403292
16.00000000 11.53687628 6.85871056
IRR ¼ rnom ¼ rlin ¼ rdir ¼ 0:08:
Introducing the error terms (10a) and (11d) for par bonds, we see that R11 ¼ 0 and
R12 ¼ 0: Furthermore, R22 indicates the error from the par. We see that we have
discount and premium bonds for C different from C ¼ 8%.
The following example shows that the Lemma 3.7 cannot be generalized to
different time to maturities.
Example 3.19 (Different Time to Maturity) We consider two par bonds with
time to maturities T1 ¼ 1 und T2 ¼ 2. We have
F1 þ C1
P1 ðrÞ ¼
1þr
with r ¼ 0.05, C1 ¼ r, and F1 ¼ 1, and
X
2
C2 F2 þ C2
P2 ðrÞ ¼ þ :
j¼1 ð1 þ r Þj ð1 þ rÞ2
with r ¼ C2 and F2 ¼ 1. We find that
rnom ¼ rlin ¼ rdir : ð3:4:23Þ
However, from Table 3.8, we see that all measurement deviates from IR, and the
difference is increasing with increasing cash flow. Thus, Lemma 3.7 is not valid.
We proceed with a generalization of Lemma 3.7.
Theorem 3.9 (Same Time to Maturity) We consider (1) and assume that the
bonds have the same time to maturity, i.e., Tj ¼ T, 1 j n, and the first m bonds
are not par.
Table 3.8 Par bond C2 IRR rlin IRRrlin

0.0500000 0.050000 0.050000 0.000000
0.0600000 0.056606 0.055000 0.001606
0.0700000 0.063199 0.060000 0.003199
0.0800000 0.069778 0.065000 0.004778
0.0900000 0.076344 0.070000 0.006344
0.1000000 0.082897 0.075000 0.007897
0.1100000 0.089437 0.080000 0.009437
0.1200000 0.095965 0.085000 0.010965
0.1300000 0.102481 0.090000 0.012481
0.1400000 0.108984 0.095000 0.013984
0.1500000 0.115475 0.100000 0.015475
C1 6¼ r1 , . . . , Cm1 6¼ rm1 , Cm 6¼ rm , Cmþ1 ¼ rmþ1 , . . . , Cn ¼ rn : ð3:4:24Þ
We find that the direct yield satisfies the equation
X
m X
n Xn
Nj Cj
Nj Pj þ Ni ¼ 0: ð3:4:25Þ
j¼1 j¼mþ1 j¼1
r
For the approximation of rdir, we have
X
m
NAVðrdir Þ ¼ R1j , ð3:4:26aÞ
j¼1
where
Fj Pj
R1j ¼ R1 Pj ; Fj ; rdir ; T ¼ Nj : ð3:4:26bÞ
ð1 þ rdir ÞT
With
Nj Pj
^j ¼
w , j ¼ 1, 2, . . . , m, ð3:4:27aÞ
P
m P
n
Ni Pi þ Ni
i¼1 i¼mþ1
and
Nj
^j ¼
w , j ¼ m þ 1, 2, . . . , n, ð3:4:27bÞ
P
m P
n
Ni Pi þ Ni
i¼1 i¼mþ1
in (3), we find that the direct yield approximation rdir is related to rlin by
P
m
R2 Cj ; Fj ; rj ; Pj
rdir ¼ rlin þ i¼1 , ð3:4:27cÞ
Pn P
n
Ni Pi þ Ni
i¼1 i¼1
i6¼m i6¼m
where
Cj rj Fj
R2i ¼ R2 Ci ; Fj ; ri ; T ¼ Nj T : ð3:4:27dÞ
1 þ rj
For the approximation properties of the error terms, we are assuming rdir > 0 for
T!1 and for j ¼ 1,. . .,m we get
Rji ! 0, i ¼ 1, 2, ð3:4:28aÞ
and for rj ! Cj
Rji ! 0, i ¼ 1, 2: ð3:4:28bÞ
Proof By extracting the indices j ¼ 1, . . . , m, we have, with (12) and
Pj ¼ Fj ¼ 1, j ¼ m þ 1, 2, . . . , n,
Xm Xn
Nj Cj Nj Cj
NAVðrÞ ¼ Nj Pj þ Nj
j¼0
r j¼mþ1
r
" #
m
X Xn
1 Nj Cj Nj Cj
Nj Fj þ Nj :
ð1 þ rÞT j¼1 r j¼mþ1
r
By adding and subtracting the price with the units on the right-side hand, this is
the same as
Xm X n
Nj Cj Nj Cj
NAVðrÞ ¼ Nj Pj þ Nj
r r
j¼1
" j¼mþ1
#
Xm Xn
1 Nj Cj Nj Cj
Nj Pj Nj Pj þ Nj Fj þ Nj :
r
ð3:4:29Þ
We neglect the difference Nj Fj Nj Pj on the right-hand side (22) of the

equation and consider the equation by using the assumption that for j 6¼ m we
have Pj ¼ Fj ¼ 1.
Xm Xn
Nj Cj Nj Cj
NAVapp ðrÞ ¼ Nj Pj þ Nj
j¼1
r j¼mþ1
r
" #
m
X Xn
1 Nj Cj Nj Cj
Nj Pj þ Nj :
r
ð3:4:30Þ
We see that
NAVapp ðrÞ ¼ 0
is the same as
X
m X
n
rNj Pj Nj Cj þ r Nj Nj Cj ¼ 0,
j¼1 j¼mþ1
i.e., the direct yield
P
n
Nj Cj
j¼0
rdir ¼ ð3:4:31Þ
P
m P
n
Ni Pi þ Ni
i¼0 i¼mþ1
satisfies (23) and (28). Furthermore, we have by (27)
X
m
Fj Pj
NAVðrÞ NAVapp ðrÞ ¼ Nj ,
j¼1 ð1 þ rÞT
and thus
X
m
Fj Pj
NAVðrdir Þ ¼ Nj :
j¼1 ð1 þ rdir ÞT
We have shown (24) and we proceed to the relation of rlin and rdir. By using the
assumption (22) of the lemma together with (13) and (29), we have
P
m 1 X
n
Nj Pj rj þ T C j Fj r j þ N j rj
i¼1 1 þ rj j¼mþ1
rdir ¼ :
P
m P
n
Ni Pi þ Ni
i¼1 i¼mþ1
Hence, we have (25)
X
m
Cj rj Fj
rdir ¼ rlin þ Nj T :
j¼1 1 þ rj
The approximation properties (26) follow from case (a) and from the explicit
expression for the error term. □
Definition 3.23 We denote with Rdir the residual value of rdir, i.e., the value that
results by evaluating (1) by rdir instead of the solution IR.
Remark 3.22 The residual Rdir in Lemma 3.7 is (8), and in Theorem 3.7 is based
on (24)
X
m
Rdir ¼ R1 Pj ; Fj ; rdir ; T :
j¼1
We will investigate the residual value of the rnom and rlin.
Corollary 3.2 For a portfolio consisting solely of perpetual bonds, the yield
to maturity is the same as the direct yield, and the solution of the (1) is equal to
(2) and (3).
Proof The assertion follows from the asymptotic behavior stipulated in Theorem
3.9 and Lemma 3.5. □
The above Theorem 3.9 gives explicit expressions for the direct yield, the
connection between the linear approximation and the direct yield, and the residual
value evaluated in the NAV equation (1a).
3.4.2 Different Approximation Scheme for the Internal Rate

of Return
In this paragraph we start with the analysis of rnom and rlin defined in (2) and (3). The
following Lemma 3.9 investigate the first order approximation and second
approximation of the discount factor for the solution of internal rate of return
(independent variable) versus the discount factor of the yield to maturity of a
bond (see also Fig. 3.17). We use in the following extensively the Landau symbol.
This indicates the magnitude of rest of Taylor series and asses the goodness of the
approximation. The precise definition is in Appendix B. We derive the following
identities:
Lemma 3.9 We consider in (1) the discount factors

1 k
1þr
and consider the following cases:
Fig. 3.17 The increment of 1+r

the IRR equation
1 1+rj
(a) For k ¼ 1 and rj, j ¼ 1,. . ., n with rj 6¼ 1, and for r 6¼ 1, we have
1 1

¼ 1 r rj þ r rj r þ O r3 þ O r2 rj þ O r rj 2 þ O rj 3 :
1þr 1 þ rj
ð3:4:32Þ
(b) For k ¼ 2, 3,. . . and rj, j ¼ 1,. . ., n with rj 6¼ 1, and for r 6¼, 1 we have

1 1 kð k þ 1Þ kðk 1Þ
¼ k 1 k r rj þ r rj r rj
ð1 þ rÞk 1 þ rj 2 2

2
þ Oðr3 Þ þ O r2 rj þ O r rj þ O rj 3 :
ð3:4:33Þ
Proof We consider case (a) and start with the reformulation that
1 1 1 1
¼ ¼ ¼
1þr 1 þ r rj þ rj 1 þ rj þ r rj
r rj
1 þ rj 1 þ
1 þ!rj ð3:4:34aÞ
2
1 r rj r rj r rj 3
¼ 1 þ E1 r; rj ,
1 þ rj 1 þ rj 1 þ rj 1 þ rj
where
1
E1 r; rj ¼ r rj : ð3:4:34bÞ
1þ
1 þ rj
We proceed by using
1 2
¼ 1 rj þ rj E2 rj , ð3:4:35aÞ
1 þ rj
where
1
E2 rj ¼ , ð3:4:35bÞ
1 þ rj
Thus
r rj D 2 E
¼ r r j 1 r j þ r j E2 r j
1 þ rj
With (34), we have by ordering the powers of rrj

1 r rj 2 2
r rj ¼ 1 r rj þ r r j r j þ r rj rj E2 rj
1þ 1 þ rj
1 þ rj

r rj 3
þ E1 r; rj :
1 þ rj
With the O-Symbol, we have by (35)

1 r rj 2
r rj ¼ 1 r rj þ r rj rj þ 1 þ rj
1þ
1 þ rj

2 3
þ Oðr3 Þ þ O r2 rj þ O r rj þ O rj
2 2
2
¼ 1 r rj þ r rj rj þ r rj 1 rj þ rj E2 rj

2 3
þ Oðr3 Þ þ O r2 rj þ O r rj þ O rj
2
¼ 1 r rj þ r rj rj þ r rj þ Oðr3 Þ þ O r2 rj

2 3
þ O r rj þ O rj :
Thus, we have
1 1
¼ 1 r rj þ r rj rj þ r rj 2
1þr 1 þ rj

2
þ Oðr3 Þ þ O r2 rj þ O r rj þ O rj 3
1

¼ 1 r rj þ r rj r þ O r3 þ O r2 rj þ O r rj 2 þ O rj 3 ,
1 þ rj
and we find (32). We proceed with k ¼ 2,. . ., j ¼ 1,. . .,n, and
1 1 1 1
¼ k ¼ k ¼ ,
ð1 þ r Þ k
1 þ r rj þ rj 1 þ rj þ r rj k r rj k
1 þ rj 1þ
1 þ rj
and, with (34) and (35), we get, by applying the binomial series, that
!k
1 r rj r rj 2 r rj 3

k ¼ 1 þ E1 r; rj
rr 1 þ rj 1 þ rj 1 þ rj
1 þ 1þrjj
!p
k
X
k r rj r rj 2 r rj 3
¼ þ E1 r; rj
p¼0
p 1 þ rj 1 þ rj 1 þ rj
!
r rj r rj 2 r rj 3
¼1k þ E1 r; rj
1 þ rj 1 þ rj 1 þ rj
!2 !
kðk 1Þ r rj r rj 2 r rj 3 r rj 3
þ þ E1 r; rj þO :
2 1 þ rj 1 þ rj 1 þ rj 1 þ rj
By arranging the linear and quadratic terms, we find, by using (31),

!
1 r r j kð k þ 1Þ r r j 2 r rj 3
¼1k þ þO
r rj k 1 þ rj 2 1 þ rj 1 þ rj
1þ
1 þ rj
2
¼ 1 k r rj 1 rj þ rj E2 rj

kð k þ 1Þ 2 2
2 r rj 3
þ r rj 1 rj þ rj E2 rj þO
2 1 þ rj
kð k þ 1Þ 2
¼ 1 k r rj þ k r rj rj þ r rj
2
2

2
þ O r þ O r rj þ O r rj
3
þ O rj 3

kð k þ 1Þ kðk 1Þ
¼ 1 k r rj þ r rj r rj
2 2

2 3
þ O r3 þ O r2 rj þ O r rj þ O rj ,
and thus we have

1 1 kð k þ 1Þ kð k 1Þ
¼ k 1 k r rj þ r rj r rj
ð1 þ rÞk 1 þ rj 2 2

2 3
þ O r3 þ O r2 rj þ O r rj þ O rj ,
i.e., we have obtain (33). □

From Lemma 3.9, we have the following corollaries. Corollary 3.3 is a prepara-
tion for Theorem 3.8, whereas Corollary 3.4 is a preparation for Theorem 3.9.
Fig. 3.18 An interval of the

real axis
Cj δ>0
Corollary 3.3 (Linear Approximation) For k ¼ 2, 3,. . . and rj, j ¼ 1,. . ., n, with
rj ∈ R1, rj 6¼ 1, and r ∈ R1, r 6¼ 1, we have
1 1
k
¼ k 1 r rj þ O r rj :
ð1 þ r Þ 1 þ rj
Corollary 3.4 (Quadratic Approximation) For k ¼ 1, 2, 3,. . . and rj, j ¼ 1,. . ., n,

with rj ∈ R1, rj 6¼ 1, and r ∈ R1, r 6¼ 1, we have
1 1
2
k
¼ k 1 k r rj þ O r2 þ O r rj þ O rj :
ð1 þ r Þ 1 þ rj
Definition 3.24 An interval Iδ, δ > 0, δ ∈ R

1
of Cj, j ¼ 1,..,n, as depicted in
Fig. 3.18 is defined by the following set:

Iδ ¼ x ∈ Cj δ; Cj þ δ :
The following theorem characterizes the residual of the linear approximations.

The part of the portfolio that matures in 1 year has a quadratic error term, and the
rest of the portfolio has a linear error term.
Theorem 3.8 (Linear Approximation) We consider a portfolio with n bonds and

yield to maturities r1,. . .,rj,. . .,rn, 1 j n, that have time to maturities
Tj ¼ 1, 1 j m, and Tj > 1, Tj ∈ N, m þ 1 j n:
By substituting rnom, rlin, resp., in (1) instead of IR, we have the following
expression for the residual value:
! ! !
X
m
Nj Fj þ Nj Cj Xn
N j C j
NAVðrÞ ¼ r rj r þ r rj r
j¼1
1 þ rj j¼mþ1
1 þ rj
!
X
n XTj
Nj Cj Nj Fj
þ k þ Tj ðk 1Þ r rj
j¼mþ1 k¼2 1 þ rj 1 þ rj
2
2
þ O r þ O r rj þ O rj
ð3:4:36Þ
and there exists an δ > 0 and a Iδ(Cj), 1 j m, such for all YTM r1,. . .,rj,. . .,rn, in
this interval we have (34) for the residual NAV(rnom), NAV(rlin), resp. More
precisely, by substituting rnom, rlin in (3) instead of IR, we find with (36) the
deviation from O when using the approximations rnom, rlin instead of IR. Thus,
for a portfolio that have bonds with 1 year to maturity (k ¼ 1, m ¼ n, resp.), we
have quadratic approximation otherwise we have only linear approximation
(k > 1, m > n, resp.).
Proof We start by assuming that the YTM are par, i.e.,

rj ¼ Cj , P rj ¼ F rj , 1 j n: ð3:4:37Þ
With (1a) we find by the hypothesis (37)

!
X
n X n X
Tj
Nj Cj Nj Fj
NAVðrÞ ¼ Nj Fj rj þ :
j¼1 j¼1 k¼1 ð1 þ rÞk ð1 þ rÞTj
We consider three parts. The first part are the bonds maturing in 1 year, and the
second are the coupons of the bonds that have maturity longer than 1 year and are
due in 1 year. The third part are the cash flows (i.e., coupons and face value) that are
due after the first year.
X
m X m Xn X n
Nj Cj Nj Fj Nj Cj
NAVðrÞ ¼ Nj Fj rj þ þ þ N j F j rj
j¼1 j¼1
1 þ r 1 þ r j¼mþ1
1 þ r j¼mþ1
!
X n X
T j
Nj Cj Nj Fj Xm
Nj Cj Nj Fj
þ ¼ þ
j¼mþ1 k¼2 ð1 þ rÞ
k
ð1 þ rÞTj j¼1
1 þ rj 1 þ rj
Xn
Nj Cj Nj Fj Nj Cj Nj Cj
þ Þþ
1þr 1þr j¼mþ1
1 þ rj 1 þ r
! !!
X n XTj
Nj Cj Nj Fj XTj
Nj Cj Nj Fj
k þ T þ
j¼mþ1 k¼2 1 þ rj 1 þ rj j k¼2 ð1 þ rÞ
k
ð1 þ rÞTj
Xm Xn
Nj Cj Nj Cj Nj Fj Nj Fj Nj Cj Nj Cj
¼ þ þ
j¼1
1 þ rj 1 þ r 1 þ rj 1 þ r j¼mþ1
1 þ rj 1 þ r
! !
X n XTj
Nj Cj Nj Cj Nj Fj Nj Fj
þ k þ T T :
j¼mþ1 k¼2 1 þ rj ð1 þ r Þk 1 þ r j j ð1 þ r Þ j
We use Lemma 3.9 in case 1 (k ¼ 1) and Corollary 3.3. As Corollary connects

the discount factors of the internal rate of return and the yield of maturity, we find
by canceling the terms of order zero
m

X Nj Fj þ Cj
NAVðrÞ ¼ r rj þ r rj rj
j¼1
1 þ rj
X
m
Nj Cj
þ r rj þ r rj rj
j¼1
1 þ rj

2
þ O r3 þ O r2 rj þ O r rj þ O rj 3
!
Xn XTj
Nj Cj Nj Fj
þ k þ Tj k r rj
2

þ O r2 þ O r rj þ O rj :
By neglecting the cubic terms, we get

Xm
Nj Fj þ Cj
NAVðrÞ ¼ r rj þ r rj rj
j¼1
1 þ rj
X
m
Nj Cj
þ r rj þ r rj rj
j¼1
1 þ rj
!
Xn XTj
Nj Cj Nj Fj
þ k þ Tj r rj
!
Xn XTj
Nj Cj Nj Fj
þ k þ T j ð k 1Þ r r j

2
þ O r2 þ O r rj þ O rj :
We consider
m
m
X Nj Fj þ Cj X Nj Cj
NAVapp ðrÞ ¼ r rj þ r rj
j¼1
1 þ rj j¼1
1 þ rj
!
X
n XTj
Nj Cj Nj Fj
þ k þ Tj r rj :
By solving for r, we find (2) and (3) under the assumption (37). As the Landau
symbols are valid on an interval, we can perturb to a not par yield rnom. The same
applies for rnom. Thus, we have the residual value (36) for all bonds in the
neighborhood of par bonds. □
j
Analogously in (1), we denote with DMac ðrÞ the Macaulay duration and with
j
DMod ðrÞ the modified duration of bond j with yield of maturity rj. We proceed by the
following two proposals for the approximation of the IR, denoted by rmac and rmod;
more specially we consider
X
n
rmac ¼ vj rj , ð3:4:38aÞ
j¼1
and with the abbreviation in (1b), we consider
j

Nj Pj Dmac rj
vj ¼ n , ð3:4:38bÞ
P i
Ni Pi Dmac rj
i¼1
And, similarly, for
X
n
rmod ¼ v~j rj ð3:4:39aÞ
j¼1
and again with the abbreviation in (1b)
j
Nj Pj Dmod rj
v~j ¼ n : ð3:4:39bÞ
P i
Ni Pi Dmod rj
i¼1
Lemma 3.10 For a portfolio consisting of n bonds (see Definition 3.11) with yield
to maturity r1,. . .,rj,. . .,rn and with Nj, 1 j n, units that matures in 1 year, it
follows that
IR ¼ rlin ¼ rmac :
And assuming in addition that the yield to maturity are the same, i.e.,
YTM ¼ rj , 1 j n,
we have
IR ¼ rmod :
Proof For a bond with 1 year to run, we have
Fj þ Cj
P rj ¼ :
1 þ rj
We use the assumptions P ¼ 1, Fj ¼ Pj with Cj ¼ rj, and consider the equation for
the IR rate of return (1)

X
n Xn
Nj Fj þ Cj
Nj Pj ¼ ,
j¼0 j¼0
1þr
X
n X
n
Nj Pj ð1 þ rÞ ¼ Nj Pj 1 þ rj :
j¼0 j¼0
By solving for r, we find (3). □
Lemma 3.11 We assume a flat curve, i.e., for a portfolio consisting of n bonds (see
Definition 3.9) with yield to maturities r1,. . .,rj,. . .,rn, with Nj, 1 j n units, we
assume
YTM ¼ rj , 1 j n:
Then there follows
IR ¼ rnom ¼ rlin ¼ rmac ¼ rmod :
Proof As the weights in (2), (3), (38), and (39) add up to 1, and all YTM in the
portfolio are the same we have
YTM ¼ rnom ¼ rlin ¼ rmac ¼ rmod ,
which entails the assertion by Lemma 3.5. □

We proceed by analyzing rmac and rmod. In the following theorem, we investigate
the residuals of rmac and rmod.
Theorem 3.9 (Approximation Macaulay Duration) We consider a portfolio with

n Bonds and yield to maturities r1 > 0,. . .,rj > 0,. . .,rn > 0, 1 j n, that have time
to maturities Tj 1 , Tj ∈ N , 1 j n. Then we have
n X
X
Tn
Nj Cj kð k 1Þ kðk þ 1Þ
NAVðrmac Þ ¼ k rmac rj rj þ r
j¼1 k¼1 1 þ rj 2 2

X Tn
Nj Fj Tj Tj 1 Tj Tj þ 1
þ T rmac rj rj þ r
j¼1 1 þ rj j 2 2
2

þ O r3mac þ O r2mac rj þ O rmac rj þ O rj 3 ,

ð3:4:40Þ
and there exists a δ > 0 and a Iδ (Cj), 1 j n, such that, for all YTM r1,. . .,rj,. . .,rn
in this interval, we have (40) for the residual NAV(rmac). More precisely, by
substituting rmac in (40), we find the deviation from O when using the approxima-
tion rmac instead of IRR.
Proof We start by assuming that the YTM are par, i.e.,
rj ¼ Cj , Pj ¼ Fj , 1 j n:
With (1a), we find

!
X n X n X Tj
Nj Cj Nj Fj
NAVðrÞ ¼ Nj Pj rj þ
k¼1 ð1 þ rÞ
k
ð1 þ rÞTj
j¼1 j¼1
! !!
X n X Tj
Nj Cj Nj Fj X Tj
Nj Cj Nj Fj
¼ k þ T þ
k¼1 1 þ rj 1 þ rj j k¼1 ð1 þ rÞ
k
ð1 þ r ÞT j
j¼1
* T +
X n X j
Nj Cj Nj Cj Nj Fj Nj Fj
¼ k þ Tj :
j¼1 k¼1 1 þ rj ð1 þ rÞ k
1 þ rj ð1 þ rÞTj
We use Lemma 3.9 and find by canceling the terms of 0th order
* * T +
X
n X j
Nj Cj Nj Fj
NAVðrÞ ¼ k k r rj þ Tj T j r rj
j¼1 k¼1 1 þ rj 1 þ rj
* T
X n X j
Nj Cj kð k 1Þ kð k 1Þ
þ k r rj rj þ r
k¼1 1 þ rj
j¼1
2 2
+
Nj Fj Tj T j 1 Tj Tj þ 1
þ T r rj rj þ r
1 þ rj j 2 2

E
2
þ O r3 þ O r2 rj þ O r rj þ O rj 3 : ð3:4:41Þ
We consider the approximation

* T +
X
n X j
Nj Cj Nj Fj
NAVapp ðrÞ ¼ k k r rj þ Tj Tj r rj
j¼1 k¼1 1 þ rj 1 þ rj
of (41). By solving for r, we find (38), and we have the residual (40). As the Landau
symbols are valid on the interval, we can perturb the not par yield. Thus, we have
the residual value (40) for all bonds in the neighborhood of the par bonds. □
3.4.3 Macaulay Duration Approximation Versus Modified Duration

Approximation
In the following theorem, we show that the modified duration yields a worse
approximation than the Macaulay duration of the IRR.
Theorem 3.10 (Macaulay Duration Versus Modified Duration) We consider a

portfolio consisting of n bonds that have YTMs with time to maturities
1 ¼ T1 . . . Tj . . . TN , Tj ∈ N , 1 j N. We assume a flat curve, i.e.,
YTM ¼ rj , 1 j n: ð3:4:42Þ
Then we have a solution IR of (1) with
IR ¼ YTM
with
rmac ¼ IR, rmod ¼ IR
and there exists a δ ∈ R1 , δ > 0, and an interval Iδ ¼ (δ, δ) such that
IR ∈ Iδ ð3:4:43Þ
and the YTM
r1 , . . . :, rj , . . . :, rn ð3:4:44Þ
are in Iδ with
0 < rmod rmac IR:
More specifically, if (42) is satisfied, we have
rmod ¼ rmac ¼ IR, ð3:4:45Þ
and if there exists an index j, 1 j n, such that
rj 6¼ IR, ð3:4:46Þ
then we have
0 < rmod < rmac < IR: ð3:4:47Þ

Proof We start by assuming that the YTM are par, i.e.
rj ¼ Cj , Pj ¼ Fj ¼ 1, 1 j n:
Following Remark 3.19, there exists a δ1 ∈ R1, 0 < δ1 < δ such that, for rj,
j ¼ 1,. . .,n, in
Iδ1 ¼ ðδ1 ; δ1 Þ,
we have
(a) for (43) and (44), we have IR ∈ Iδ1

(b) NAV(r), r ∈ (δ1, δ1) is monotonically decreasing
(c) IR is the only solution of (1) in Iδ1
We first consider (42). Then, from (1), we have
NAVðIRÞ ¼ 0
and as the weights (38) and (39) sum up to one we have
rmac ¼ IR and rmod ¼ IR
and thus
NAVðrmac Þ ¼ 0, NAVðrmod Þ ¼ 0:
We proceed with the assertion (47) and by (1), we have

* T + * T +
Xn X j
Nj Cj Nj X n X j
Nj Cj Nj
NAVðrÞ ¼ k þ T þ
j¼1 k¼1 1 þ rj 1 þ rj j j¼1 k¼1 ð1 þ rÞ
k
ð1 þ rÞTj
* T + * T +
Xn X j
Nj Cj Nj Cj X n X j
Nj Nj
¼ k þ k
j¼1 k¼1 1 þ rj ð1 þ r Þk j¼1 k¼1 1 þ rj ð1 þ rÞTj
From Lemma 3.9 we have for r ¼ IR

1 1 kð k þ 1Þ kð k 1Þ
¼ k 1 k IR rj þ IR rj IR rj
ð1 þ IRÞk 1 þ rj 2 2

2
þ O IR3 þ O IR2 rj þ O IR rj þ O rj 3
This the same as


1 1
¼ k 1k IRrj ð1þIRÞk IRrj IR
ð1þIRÞk 1þrj

kðkþ1Þ kðk1Þ 3 2 2 3
þ IRrj IR rj þO IR þO IR rj þO IR rj þO rj ,
2 2
thus

1 1 kð k 1Þ 2
¼ k 1 k IR rj ð1 þ IRÞ þ IR rj
ð1 þ IRÞk 1 þ rj 2

2
þ O IR3 þ O IR2 rj þ O IR rj þ O rj 3 :
We sum up and find

* * T !+
Xn X j
Nj Cj Nj Fj
NAVðIRÞ ¼ k k IR rj ð1 þ IRÞ þ Tj Tj IR rj
1 þ rj 1 þ rj
j¼1
* k¼1 2
Xn X Tj
N j Cj kðk 1Þ
þ k IR rj
k¼1 1 þ rj
j¼1
2
+
Nj Fj Tj Tj 1 2
þ Tj IR rj O IR3 þ O IR2 rj
1 þ rj 2

2
þ O IR rj þ O rj 3 Þi ¼ 0:
We neglect the cubic terms and define the NAV1(r)

* * ! +!
X
n X
Nj Cj
Tj
Nj Fj
NAV1 ðrÞ¼ k k rrj ð1þrÞ T Tj rrj
1þrj 1þrj j
j¼1
* T k¼1
+
Xn X j
Nj Cj kðk1Þ 2 Nj Fj Tj Tj 1 2
k rrj þ T rrj :
j¼1 k¼1 1þrj
2 1þrj j 2
Then there exists a δ2 ∈ R1, δ2 > 0 with 0 < δ2 < δ1
lδ2 ¼ ðδ2 ; δ2 Þ,
and a IR0 in Iδ2 such that
NAVðIR0 Þ ¼ 0
and as the quadratic error are positive we have

* !
X
n
Nj Cj
k k IR0 rj ð1 þ IR0 Þ
j¼1 1 þ rj
+
Nj Fj
þ T Tj IR0 rj ð1 þ IR0 Þ > 0:
1 þ rj j
The there exists a δ3 ∈ R1, δ3 > 0 with O < δ3 < δ3 with
Iδ3 ¼ ðδ3 ; δ3 Þ,
such that
* * !+
X
n X
Tj
Nj Cj Nj Fj
k k IR rj þ Tj Tj IR rj > 0:
j¼1 k¼1 1 þ rj 1 þ rj
We consider
gð r Þ ¼ a 1 r b1
where
X
n X
n
a1 ¼ j
Nj Dmac r j , b1 ¼ j
Nj Dmac rj rj :
j¼1 j¼1
We have g(IR) > 0 and we look at the line between g(0) ¼ b1 and g(IR), and as
g(0) < 0, we have
0 < rmac < IR:
We consider
hð r Þ ¼ a 2 r b2
where

X
n
j
X
n j
Dmac rj Xn rj
a2 ¼ Nj Dmod rj ¼ Nj ¼ Nj Dmac rj 1
j
j¼1 j¼1
1 þ rj j¼1
1 þ rj

X
n
j
X
n j
Dmac rj Xn rj
b2 ¼ Nj Dmod rj rj ¼ Nj rj ¼ Nj Dmac rj 1
j
rj :
j¼1 j¼1
1 þ rj j¼1
1 þ rj
We look at the line between the differences

gðrmac Þ hðrmac Þ > 0
and the intersection of the vertical axis
gð 0Þ ¼ b1 > b2 ¼ hð 0Þ
and we conclude (47).

As the Landau symbols are valid on the interval, we can perturb to intervals of
the par yields. The proof is thus completed. □
Example 3.20 We choose the parameter of the Example 3.16. Although we

consider two zero bond and not par bond we find with
rmac ¼ 0:03333640, and
rmod ¼ 0:03320328, and
0 < rmod < rmac < IR
the statement (47) of Theorem 3.10. We do not discuss the magnitude of the
deviation from a flat curve and par bonds. Theorem 3.10 is only valid locally, i.e.,
our claims assume that there exists an open interval around the flat curve.
Example 3.21 We consider two par bonds with prices
F þ C1
P 1 ðr 1 Þ ¼ ,
1 þ r1
C2 F þ C2
P2 ðr2 Þ ¼ þ ,
1 þ r2 ð1 þ r2 Þ2
with C1 ¼ 1%, C2 ¼ 9%, r1 ¼ C1, r2 ¼ C2, and find
IRR ¼ 0:06279
D1mac r1 þ D2mac r2 1∗ 0:01 þ 1:91∗ 0:09

rmac ¼ ¼ ¼ 0:06258,
Dmac þ Dmac
1 2 1 þ 1:91
D1mod r1 þ D2mod r2 0:9900∗ 0:01 þ 1:7591∗ 0:09

rmod ¼ ¼ ¼ 0:06119:
D1mod þ D2mod 0:9900 þ 1:7591
Thus we have
0 < rmod < rmac < IR:
In Fig. 3.19 we see the difference of the NAV and the line g.
Fig. 3.19 Approximation of 2.E-03

the NAV
0.E+00
0.00 0.02 0.04 0.06 0.08 0.10
-2.E-03
-4.E-03
-6.E-03
-8.E-03
-1.E-02
-1.E-02
Example 3.22 We consider two zero bonds with prices
F
P 1 ðr 1 Þ ¼ ,
1 þ r1
F
P2 ðr2 Þ ¼ ,
ð1 þ r2 Þ2
and choose r1 ¼ 0.00 and F ¼ 1 with
r2 ¼ k 10%, k ¼ 0, 1, . . . , 8:
We find, for (1a),
1 1 1 1
NAVðrÞ ¼ þ :
1 þ r1 ð1 þ r2 Þ2 1 þ r ð1 þ rÞ2
For the residual in r1, we find
1 1
NAVðr1 Þ ¼ 2
,
ð1 þ r2 Þ ð1 þ r1 Þ2
and for the residual in r1 we find
1 1
NAVðr2 Þ ¼ :
1 þ r1 1 þ r2
Based on (38), we have
X
2
rmac ¼ vj r j
j¼1
with
1
j
Dmac rj
j
Pj Dmac rj 1 þ rj
vj ¼ ¼ i :
P2 P2 1
i
Pi Dmac ðri Þ Dmac ðri Þ
i
i¼1 i¼1 1 þ ri
2
1 1
2
1 þ r1 1 þ r2
rmac ¼ 2 r1 þ 2 r2 :
1 1 1 1
þ2 þ2
1 þ r1 1 þ r2 1 þ r1 1 þ r2
For the approximation by the modified duration, we have

2 3
1 1
2
1 þ r1 1 þ r2
rmod ¼ 2 3 r1 þ 2 3 r2 .
1 1 1 1
þ2 þ2
1 þ r1 1 þ r2 1 þ r1 1 þ r2
From (1), we have
F F
P1 ðr1 Þ þ P2 ðr2 Þ ¼ 2
:
ð1 þ rÞ ð1 þ r Þ2
And, using the price function, we find
F F F F
2
þ 2
¼ 2
þ :
ð1 þ r 1 Þ ð1 þ r 2 Þ ð1 þ rÞ ð1 þ rÞ2
The IR can be explicitly calculated by solving a quadratic equation [1]. In

Fig. 3.20, we show the difference
IR rmac , IR rmod :
As shown in Theorem 3.10, we see that rmac and rmod underestimate the IR and
rmac is a better approximation than rmod.
Although we have not par bonds in this example,
rmod rmac ð3:4:48Þ
can be shown explicitly. With a1 ¼ 1 + 2, b1 ¼ r1 + 2 r2
1 2
a2 ¼ þ ,
ð1 þ r1 Þ2 ð1 þ r2 Þ2
0.14
0.12
0.10
0.08
Erorr versus 0.06 Mac

IRR
Mod
0.04
0.02
0.00
-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8
-0.02
Yield of the zero bond
Fig. 3.20 Approximation of two zero bonds
r1 2r2
b2 ¼ 2
þ :
ð1 þ r 1 Þ ð1 þ r 2 Þ2
(48) is the same as
b2 b1

a2 a1
thus
a 1 b2 a 2 b1
3r1 6r2 r1 2r1 2r2 4r2

a 1 b2 a 2 b1 ¼ 2
þ 2
2
2
2

ð1 þ r1 Þ ð1 þ r 2 Þ ð1 þ r 1 Þ ð1 þ r2 Þ ð1 þ r 1 Þ ð1 þ r 2 Þ2
2r1 2r2 2r1 2r2 ðr1 r2 Þ2
¼ þ ¼ 2 :
ð1 þ r1 Þ2 ð1 þ r2 Þ2 ð1 þ r2 Þ2 ð1 þ r1 Þ2 ð1 þ r 2 Þð1 þ r 2 Þ
The equality holds if and only if r1 ¼ r2.
Remark 3.23 (The Approximation of IRR by Macaulay Weight Versus

Modified Duration Weights) We give an intuitive explanation why the approxi-
mation of the internal rate of return by Macaulay duration is superior to modified
duration. In Theorem 3.9, we have decomposed the bond portfolio into zero bonds.
For a zero bond, the Macaulay duration is equal to the time to maturity, and the
linear terms vanish and the NAV consists only of quadratic terms. This process is
unique. But by substituting, the modified duration linear term does not vanish, and
the NAV is bigger.
3.4.4 Calculating the Macaulay Duration
We refer to (3.3.2) and consider the Macaulay duration at issuance or just after the
coupon payment. The Macaulay duration Dmac(r) is then defined by
P
N C F
k þN
k¼1 ð1 þ r Þ k
ð1 þ rÞN
Dmac ðrÞ ¼ : ð3:4:49aÞ
P
N C F
þ
k¼1 ð1 þ r Þk ð1 þ rÞN
This is the same as
P
N C F
k þN
k¼1 ð1 þ rÞ k
ð1 þ r ÞN
Dmac ðrÞ ¼ ð3:4:49bÞ
PðrÞ
where P(r) is the price of the bond. The value of the Macaulay duration depends on
the coupon, the time to maturity, and interest rate. Mostly the yield to maturity for a
bond is substituted for the interest rate. This is consistent with the formulae
introduced in (2), (3), and (39) as they reduce to the yield to maturity for a bond
portfolio that reduces to a single bond. Here we consider a bond portfolio and recall
(3.3.5). The Macaulay duration of a portfolio is defined by
! !
Xn XTj
Nj Cj Nj Fj Xn XTj
Nj Cj Nj Fj
k þ Tj k þ Tj
j¼1 k¼1 ð1 þ rÞ
k
ð1 þ r ÞT j j¼1 k¼1 ð1 þ rÞ
k
ð1 þ r ÞT j
Dmac ðrÞ ¼
Po
! ¼ :
X n X Tj
Nj Cj Nj Fj PoV
þ
j¼1 k¼1 ð1 þ rÞ
k
ð1 þ r ÞT j
We discuss different possibilities for the interest rates (see Fig. 3.21). In the
commercial software, the yield to maturity approach is mostly used
!
P
n P
Tj
Nj Cj Nj Fj
k k þ Tj T
j¼1 k¼1 1 þ rj 1 þ rj j
Po
DMac ¼ ! :
Pn PTj
Nj Cj Nj Fj
k þ T
j¼1 k¼1 1 þ rj 1 þ rj j
r1,r2,….,rn
Yield to maturity (YTM)
IRR YTM
(Internal rate of rate) approach
r = rtrue r=r dur r = rlin d1,d2,….,dn
durtrue durdur durlin Dur =
Fig. 3.21 Different calculation of the Macaulay duration
This approach is based in the flat yield concept. The yield to maturity of each
individual bond is substituted. The theoretical drawback is that we use different
interest rates at the same time, and that is the main caveat of the flat yield concept. If
the yield is flat or nearly flat, the approach is acceptable.
We propose to use the IR or an approximation thereof and present some
numerical experiment in the following section.
We proceed by compiling some analytic expression for calculating the Macaulay
duration. In the following lemma, we discuss the price function relating to different
interest rate.
Lemma 3.12 (Price Approximation of a Bond and Bond Portfolio) We denote

with rapp one of the approximations rnom (see (2)), rlin (see (3)), rdir (see (4)), rmac
(see (38)), or rmod (see (39)). Then we have with
Δrapp ¼ rapp IR, ð3:4:50Þ
and the discrete version DDmod [see (3.3.6) and (3.3.8)] for a bond with price P(r)
1 1 2

¼ 1 DDmod rapp Δrapp þ o Δrapp ð3:4:51aÞ

PðIRÞ P rapp
and for a bond portfolio Po(r)
1 1 2
¼ 1 DDmod rapp Δrapp þ O Δrapp : ð3:4:51bÞ

PoðIRÞ Po rapp
Proof By the right-hand side of (51a), we have
1 1
¼
PðIRÞ P rapp P rapp þ PðIRÞ
1
¼ !:
P rapp PðIRÞ
P rapp 1
P rapp
By using the discrete version of the modified duration (see Definition 3.18), we
have by (50)
ΔPðrÞ
Δr
DDmod ðr; ΔrÞ ¼ ,
PðrÞ
and, by using the abbreviation (49), we find the assertion (51a) of the lemma. The
assertion (51b) follows analogously. □
The following theorem discusses the different duration when changing the level.
The following theorem decomposes the error between the IR and the approximation
rapp when evaluating the Macaulay duration of the bond. The linear term has two
parts. The first term stems from evaluating the denominator and the quadratic cross
terms, and the second term comes from the price approximation in the nominator.
The corresponding result for a bond portfolio is in Theorem 3.9.
Theorem 3.8 (Approximation Macaulay Duration of Bond) We denote with

rapp one of the approximation rnom (see (2)), rlin (see (3)), rdir (see (4)), rmac (see
(38)) or rmod (see (39)). Then we have
1 n
Dmac rapp Dmac ðIRÞ ¼ K1 : Δrapp þ K2 Δrapp 1 þ DDmod Δrapp
Papp

o
2
þ O rapp þ O rapp IR þ O IR2
ð3:4:52aÞ
where Δrapp is defined by (53) and
X
N
k2 C N2 F
K1 ¼ k þ N ð3:4:52bÞ
k¼1 1 þ rapp 1 þ rapp
and
!
X
N
kC NF
K2 ¼ k þ N DDmod : ð3:4:52cÞ
k¼1 1 þ rapp 1 þ rapp
Proof By (49) and Lemma 3.12, we have

!
1 XN
kC NF
Dmac rapp Dmac ðIRÞ¼ þ N
P rapp k¼1 1 þrapp k 1 þ rapp
! !
1 XN
kC NF 1 X N
kC NF
þ ¼ þ N
PðIRÞ k¼1 ð1 þIRÞk ð1 þ IRÞN P rapp k¼1 1 þrapp k 1 þ r! app
1 XN
kC NF 2
þ 1DD mod r app Δrapp þO Δr app

P rapp k¼1 ð1 þ IRÞk ð1 þ IRÞN
!
1 XN
kC kC 2
¼ 1DDmod rapp Δrapp þO Δrapp

P rapp k¼1 1 þrapp k ð1 þ IRÞk
!
NF NF 2
þ N 1DDmod rapp Δrapp þO Δrapp :

1 þ rapp ð1 þ IRÞN
ð3:4:53Þ
By Corollary 3.3 we have
1 1
2
k
¼ N 1 k IR rapp þ O rapp
ð1 þ IRÞ 1 þ rapp
1
þO rapp IR þ O IR2 ¼ N 1 þ k rapp IR

1 þ rapp
2
þO rapp þ O rapp IR þ O IR2
and with (53) we find
X N
Dmac rapp Dmac ðIRÞ 1 kC kC
¼ k k
P rapp k¼1 1 þrapp 1 þ rapp

2
1kΔrapp þO rapp þO rapp IR þO IR2
2
NF
1þDDmod rapp Δrapp þO Δrapp þ N
1 þ rapp
NF
2
N 1NΔrapp þO rapp
1 þ rapp

þO rapp IR þO IR2 Þ
2
1þDDmod rapp Δrapp þO Δrapp :
By arranging the terms and by canceling the term 0ter order

1 XN
kC
Dmac rapp Dmac ðIRÞ¼ k kΔrapp þDDmod rapp Δrapp
P rapp k¼1 1 þ rapp
2

2
þkDDmod rapp Δrapp þO rapp þO rapp IR
NF
þO IR2 Þþ N NΔrapp þ DDmod rapp Δrapp
1 þ rapp
2

2
þN DDmod rapp Δrapp þO rapp þO rapp IR

þO IR2 ÞÞj
which yields the assertion of the theorem. □
Theorem 3.9 (Macaulay Duration of a Bond Portfolio) We denote with rapp one
of the approximations rnom (see (2)), rlin (see (3)), rdir (see (4)), rmac (see (36)) or
rmod (see (37)). Then we have with (39b)
1
Po
Dmac rapp Dmac
Po
ðIRÞ ¼ fK1 Δrapp
Poapp
2
þK2 Δrapp 1þDDmodP

Δrapp þ O rapp

þO rapp IR þO IR2 Þg
where
!
X
n X
tj
k2 Nj Cj N2j Fj
K1 ¼ k þ N
j¼1 k¼1 1 þ rapp 1 þ rapp
and
!!
X
n X
Tj
kNj Cj Nj Fj
K2 ¼ k þ N
Po
DDmod
j¼1 k¼1 1 þ rapp 1 þ rapp
Proof We apply the proof of Theorem 3.8 to a portfolio. □
3.4.5 Numerical Illustrations
We start with examples that constituent of two bonds. First we consider two bonds
that fit into the framework for Lemma 3.7 and use again the data from Example
3.18. Then we apply (18) to the bonds consider in Example 3.19 and compare the
different approximations to IR. In Example 3.25 we consider zero bonds and

investigate the error of IR when evaluating (18) and (19).
Example 3.23 (Continuation of Example 3.18) We again use the date from
Example 3.20. With (38) and (39), we find by using r2 ¼ 8%, and then we have
IR ¼ rmod ¼ rmac ¼ 8%:
We consider
r2 ¼ 8% α0:5%, α ¼ 4, 3, 2, 1, 0:
And with the coupons in Table 3.5, we have the full problem we have tackled in
Lemma 3.7. We see in Fig. 3.22 that the approximation with Macaulay duration
formulated in (38) is best for approximating IR.
The following example shows the easiest portfolio of two bonds with different
times to maturity.
Example 3.24 (Continuation of Example 3.19) We again use the date from
Example 3.21. By referring to Table 3.8 and (23), we see that the linear approach
and the direct yields the same result which is different from the numerical value for
IR. Figure 3.23 shows that the quadratic approach with the Macaulay approxima-
tion (38) is much better than all linear measurement introduced here.
Example 3.25 (Zero Bonds, Continuation of Example 3.20) As in Example

3.22, we consider two zero bonds with price
0.0002
0.0001
0.0000
6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0%
-0.0001 Error linear
Error Duration
-0.0002 Error Nomial
-0.0003
-0.0004
-0.0005
Fig. 3.22 Different approximation of the IRR

0.2%
0.0%
1 2 3 4 5 6 7 8 9 10 11
-0.2%
-0.4%
-0.6%
IRR - rlin
-0.8%
IRR - rmac
-1.0%
-1.2%
-1.4%
-1.6%
-1.8%
Fig. 3.23 Linear versus quadratic
Table 3.9 IRR and its approximation

r2 (%) IRR IRR-rnom IRR-rlin IRR-rmac IRR-rmod
2.5 0.0333592 0.0041408 0.0041445 0.0000225 0.0001559
3.0 0.0367271 0.0032729 0.0033245 0.0000145 0.0001000
3.5 0.0400751 0.0024249 0.0024999 0.0000082 0.0000564
4.0 0.0434032 0.0015968 0.0016709 0.0000037 0.0000251
4.5 0.0467115 0.0007885 0.0008376 0.0000009 0.0000063
5.0 0.0500000 0.0000000 0.0000000 0.0000000 0.0000000
5.5 0.0532689 0.0007689 0.0008417 0.0000009 0.0000063
6.0 0.0565182 0.0015182 0.0016875 0.0000037 0.0000253
6.5 0.0597480 0.0022480 0.0025372 0.0000085 0.0000570
7.0 0.0629585 0.0029585 0.0033908 0.0000151 0.0001015
7.5 0.0661496 0.0036496 0.0042482 0.0000237 0.0001588
F F
P1 ðr1 Þ ¼ , P2 ðr2 Þ ¼ :
1 þ r1 ð1 þ r 2 Þ2
and choose F ¼ 1 and r1 ¼ 5%. We vary over r2 and we see that the approximations
(2), (3), (38), and (39) are different, except we have a flat yield curve consisting of
entry r1 and r2 (compare Lemma 3.11). Table 3.9 illustrates Theorem 3.6–3.8.
In Fig. 3.24 we illustrate Corollary 3.2 and 3.3 with the second bond by the
quadratic approximation
0.02
0.01
0.00
2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5%
-0.01
-0.02
quadratic error
-0.03 linear error
-0.04
-0.05
-0.06
-0.07
Fig. 3.24 Approximation of discount factor
1
2
¼ 1 2r2 þ Oððr2 ÞÞ2 ,
ð1 þ r2 Þ
and the linear approximation
1
¼ 1 r2 þ Oðr2 Þ:
ð1 þ r2 Þ2
Definition 3.25 We consider a yield curve considering the following yield
r1 > 0, . . . , rj > 0, . . . , rn > 0, 1 j n
and the time points
t1 > 0, . . . , tj > 0, . . . , tn > 0, 1 j Tn :
We discuss three cases:
(a) If
r1 ¼ r2 , . . . rj ¼ rjþ1 . . . , rn1 ¼ rn , 1 j n
the yield curve is said to be flat.

Table 3.10 Different Portfolio r1 (%) r2 (%) r3 (%)

credit qualities
1 6 6 6
2 4 6 8
3 2 6 10
Table 3.11 Different (1) + (2) (38) (IRR)

approximation of par bonds
6.0000% 6.00000% 6.00000%
6.0000% 5.97581% 6.00000%
6.0000% 5.90317% 6.00000%
(b) If
r1 > r2 , . . . rj > rjþ1 . . . , rn1 > rn , 1 j n
the yield curve is said to be normal.
(c) If
r1 < r2 , . . . rj < rjþ1 . . . , rn1 < rn , 1 j n
the yield curve is said to be inverted.
Example 3.26 (Continued Example 3.17, Par Bond) We consider again three par
bonds with the same time to maturity Ti ¼ 3. The portfolios can be considered as a
credit portfolios with bonds that have the same time to maturity. In Portfolio
1 (α ¼ 0), all bonds have the same credit quality. In Portfolios 2 and 3 (α ¼ 2,
α ¼ 2), we assume two different portfolios with different credit. In Table 3.10 we
assume three portfolios with different par yield.
The IRR in the Table 3.11 follows from (21).
We see that the Macaulay duration approach (38) yields a wrong result.
Example 3.27 (Not Par, Same Time to Maturity) We consider three bonds with
coupon 2% and the time to maturity T ¼ 3. As exposed in Table 3.12, we assume
first a flat curve and then two choices with discount bonds.
Table 3.13 shows the results of our calculation.
We see that (38) can be a better and a worse approximation of the IIR than (2).
Example 3.28 (Different Time to Maturity) We consider three bonds with

Coupon C ¼ 6% with N1 ¼ 1, N2 ¼ 1, N3 ¼ 1. Furthermore we assume time to
maturities T1 ¼ 1, T1 ¼ 2, T1 ¼ 3 and three yield scenarios r1, r2, r3 as specified in
the Table 3.14.
Table 3.15 shows the results of our calculation.
We see that (2) is a much better approximation of the IRR that (1)
Table 3.12 Different Scenario r1 (%) r2 (%) r3 (%)

yield of maturity
1 2 2 2
2 2 4 6
3 2 8 12
Table 3.13 Approximati- (1) (2) (38) (IRR)

on of the IRR
2.0000% 2.00000% 2.00000% 2.00000%
4.00000% 3.92464% 3.92379% 3.94907%
7.33333% 6.86353% 6.85795% 7.01624%
Table 3.14 Yield Scenario r1 (%) r2 (%) r3 (%)

scenario
1 6 6 6
2 0 6 12
3 12 6 0
Table 3.15 Flat versus (1) (2) (IRR)

non-flat curve
6.0000% 6.00000% 6.00000%
6.0000% 7.58253% 7.58107%
6.0000% 3.75359% 3.76000%
Example 3.29 (Yield Spread, Different Time to Maturities) We consider three

bonds with Coupon C ¼ 9% with Nj ¼ 1, j ¼ 1, 2, 3, and the time to maturities are
T1 ¼ 4, T2 ¼ 9, T3 ¼ 14. We assume with r2 ¼ 9% and considered:
1. r1 ¼ r2 α, r3 ¼ r2 + α (normal yield curve)

2. r1 ¼ r2 + α, r3 ¼ r2 α, (inverted yield curve)
We chose α ∈ N between 1% α 5%. The Figs. 3.25 and 3.26 shows the
difference of the different approximation for IR. We see that the duration
approximations (38) yield the best approximation. Figures 3.27 and 3.28 are the
accompanying Macaulay duration calculations.
Example 3.30 (Yield Spread, Same Time to Maturities) We consider three

bonds with Coupon C ¼ 9%, with Ni ¼ 1, i ¼ 1, 2, 3. We assume r1 ¼ 2%,
r2 ¼ 9%, r3 ¼ 16% and vary over the time to maturities of the portfolio T ∈ N and
10 T 15. Figures 3.29 and 3.30 show the difference of the different
approximations of IR and the accompanying Macaulay duration calculations. The
approximation error of the IRR is a linear function of the time to maturity. The
linear approximation is the best approximation in which is in line with Examples
3.19 and 3.26.
yield spread (normal)

10.00%
9.50%
9.00%
IRR
8.50%
Nom
lin
8.00% MacDur
7.50%
7.00%
9 10 11 12 13 14
yield long maturity bond
Fig. 3.25 Approximation of IR for increasing yields
yield spread (inverse)

10.0%
9.5%
9.0%
8.5%
8.0%
IRR
7.5% Nom
lin
7.0%
MacDur
6.5%
6.0%
5.5%
5.0%
Fig. 3.26 Approximation of IR for decreasing yields

Macaulay Duration in years (normal)

6.40
6.20
6.00
5.80 Durshort
DurIRR
5.60 Dur yield nom
duryield lin
5.40 durMac
5.20
5.00
9 10 11 12 13 14
Fig. 3.27 The Macaulay duration calculation for increasing yields
Macaulay Duration in years (inverse)

7.40
7.20
7.00
6.80
6.60 Durshort
DurIRR
6.40 Dur yield nom
duryield lin
6.20
durMac
6.00
5.80
5.60
9 10 11 12 13 14
Fig. 3.28 Macaulay duration calculation for decreasing yields

Yield spread 1 400 bps

10%
9%
Approximaon for the IRR
IRR
8%
Nom
LIN
7% MacDur
6%
5%
10 11 12 13 14 15
Time to Maturity
Fig. 3.29 Same time to maturity of the bonds
Macaulay Duration in years

10.0
9.5
9.0
8.5
Dur IRR
8.0 Dur yield nom
7.5 Dur yield lin

Dur Mac
7.0
Dur short
6.5
6.0
10 11 12 13 14 15
Time to Maturity
Fig. 3.30 Different duration measures
Remark 3.24 As introduced in Definition 3.6, the flat yield curve concept assumes
that every cash flow of a single bond is discounted with the same yield, but we know
that we have different yield for different time to maturities and coupons at the same
time are discounted with different yields. In a riskless world, this makes little sense.
We need a model that derives from the observed yield to maturity the fair spot rate
for any time.
Remark 3.25 Credit bond can also be tackled with the consideration on the yield to
maturities given in this chapter. However, with the duration introduced so far does
not reflect credit risk. If yields are increasing because of a possible credit event-like
default, we would say that the duration is diminishing, and we have less risk which
is a wrong conclusion in our context.
References
1. Wolfgang M (2015) Portfolio analytics, 2nd edn. Springer International Publisher, Cham
2. Yuri S, Wolfgang M (2011) Properties of the IRR equation with regards to the ambiguity of
calculating the rate of return and a maximum number of solutions. J Perform Meas 15
(3):302–310
3. Spiegel MR (1971) Finite differences and difference equations, Schaum’s outline series.
McGraw-Hill Book Company, New York
4. Neil R (2003) Currency overlay. Wiley, Hoboken, NJ
The Term Structure of Interest Rate
4
In this chapter, we depart from the flat yield concept (see Definition 3.6) as
discussed in Chap. 3. The flat yield concept allows different discount factors
for different bonds although cash flow occurs at the same time in the future.
The concept of time value of money does not allow this situation and spot
curves avoid this deficiency. Figure 4.1 shows the backbone of this chapter.
We discuss the transition from yield curve to spot curves and spot curves to
forward curves.
Figure 4.1 refers to a specific time and does not say anything about the
dynamic of the curve. Starting point is a set of bonds of similar quality and the
accompanying market price. The set of yield is the input to a scatterplot
showing the time versus to yield. The term yield curve suggests that we can
find a yield to maturity for any time. Yield curve modelling then refers to the
transition for the scatterplot to a curve. It is often said that the spot rates are the
basis of a specific bond universe. Spot rates have a wide area of application like,
for instance:
• Scenario analysis for a bond portfolio

• Rich/cheap analysis of the price of a bond paid in market
• Price of a recently issue bond
The forward rate gives an indication of future interest rates. The material here
discussed is also extensively discussed in the literature (see, e.g., [1, 2]). We confine
our exposition to some basic ideas and concepts.

104 4 The Term Structure of Interest Rate
Fig. 4.1 Different curves

based on market data
forward rate curve
Spot rate curve
yield curves
Actual Bond Prices
4.1 Spot Rate and the Forward Rate
In this section, we discuss the basic concept of the term structure of the interest rate.
We consider a partition of the time axis with unit year
t0 ¼ 0, : . . . , tk < tk1 , . . . , tN ¼ T ð4:1:1aÞ
of the interval [0, T], and
k1 hk ¼ tk tk1 , k ¼ 1, . . . , N ð4:1:1bÞ
is the time span between tk and tk1.
Definition 4.1 The yield to maturity of a zero coupon bond with time to maturity
t ∈ R1 is denoted by st and is called the interest zero rate or simply the zero rate
for time t ∈ R1 and t ∈ [0, T].
In the following, we assume that the zero rates s(t) and t ∈ R1 are given for any
time t ∈ R1 and t ∈ [0, T]. In Definition 4.1, it is assumed that the interest rate
starts at t ¼ 0.
4.1 Spot Rate and the Forward Rate 105
Fig. 4.2 Forward rate 0 1 2
s1 1f2
1
s2
Definition 4.2 An annual interest rate k1fk that starts with a time t > 0 over the
time span [tk1, tk] in the future is called a forward interest rate or simply a
forward rate.
Remark 4.1 The notation k1fk, k ¼ 1, . . . , N implicitly assumes that the forward
rate is constant and that there is no compounding in the time period k1tk.
We consider a spot rate curve s(tk), k ¼ 1, . . . , N. Forward rates are derived from
the spot rates. They are indicators of future interest rate implied from a no arbitrage
condition which states that an investor that first invests $1 in the period 1 and then
reinvests in period 2 must receive the same amount that as an investor that invests
$1 over both periods (see Fig. 4.2). The spot rates s1 and s2 with s1 < s2 and the
forward rate 1f2 are related by
ð1 þ s2 Þ2 ¼ ð1 þ s1 Þ ð1 þ 1 f 2 Þ: ð4:1:2Þ
Interest rates are always referring to a time span. In (2), it is assumed that the
period 1 and period 2 have the same length. In most cases, the interest rate is quoted
annually, and the underlying period is years.
The calculation of the right side of (2) reflects an investor that receives interest
after period 1 and reinvests in period 2. We speak of compounding, more specially
we have the following definition:
Definition 4.3 Compounding is the reinvestment of the income to earn more

income in the subsequent periods. If the income and the gains are retained within
the investment vehicle or reinvested, they will accumulate and contribute to the
starting balance for each subsequent period’s income calculation.
Example 4.1 We assume that the unit is years with the spot rate s1 ¼ 2.0000% for
the first year and the spot rate s2 ¼ 2.5000% for the first 2 years. Referring to (1), we
have N ¼ 2 and t0 ¼ 0, t1 ¼ 1, and t2 ¼ 2. The forward rate between the end of the
first year and the end of the second year is then
ð1 þ s2 Þ2
1f2 ¼ 1: ð4:1:3Þ
ð1 þ s1 Þ
The numerical value is
1f2 ¼ 3:0025%:
Because the spot curve is upward sloping, we see that the forward rate is above
the two spot rates.
We generalize (2) by considering a fraction of the underlying base unit. Here the
base unit is not equal to the validity of the interest rate. From (1, 2), we have
ð1 þ h s2 Þ2 ¼ ð1 þ h s1 Þ ð1 þ h 0 f 1 Þ:
Example 4.2 We assume that the unit is years with the spot rate s1 ¼ 2.0000% for
the first half year and the spot rate s2 ¼ 2.5000% for the second half year. Referring
to (1), we have N ¼ 2 and t0 ¼ 0, t1 ¼ 0.5, and t2 ¼ 1. Based on (3) the numerical
value is
1f2 ¼ 3:0012%:
By iterating (3) for k ¼ 2, . . . , N, the term structure of the spot rate is then related
to the forward rate by

ð1 þ h sk Þk ¼ ð1 þ h s1 Þ 1 þ h 1 f 2 . . . 1 þ h k1 f k , 1 k N,
and with s1 ¼ 0f1 we have

ð1 þ h sk Þk ¼ 1 þ h 0 f 1 1 þ h 1 f 2 . . . . . . : 1 þ h k1 f k : ð4:1:4aÞ
We see that the spot rates are the geometrical compounded means of the forward
rates. We compound twice
k 2 2 2
h h h h
1 þ sk ¼ 1 þ 0 f 1 1 þ 1 f 2 . . . . . . 1 þ k1 f k
2 2 2 2
and by iterating, we find for continuous compounding
eh ksk ¼ eh0 f 1 eh 1 f 2 eh k1 f k : ð4:1:4bÞ
Definition 4.4 The yield to maturity of a zero coupon bond at issuance time tB > 0,
with time to maturity tE ∈ R1, with tB < tE, is called the forward yield and is
denoted by BsE, and the forward rate yield curve is a plot of the forward rate against
the term to maturity.
4.2 Discrete Forward Rate and the Instantaneous Forward Curve 107
By using the notation in Definition 4.4, (4b) is the same as

k
1 þ h 0sk ¼ 1 þ h 0 f 1 1 þ h 1 f 2 . . . . . . : 1 þ h k1 f k :
The term structure of the forward yield after the first period
j
1 þ h 1sj ¼ 1 þ h 1 f 2 . . . . . . : 1 þ h j1 f j , 1 j N, ð4:1:5aÞ
and, more generally, after the k-th period

k
1 þ h k s j ¼ 1 þ h k f kþ1 1 þ h j1 f j , 0 k < j N: ð4:1:5bÞ
We see that there is a forward rate at every time point tk in the future and an
accompanying forward yield curve. This leads to the following remark:
Remark 4.2 In an optimization tool, the economist is considering the forward

curve at his time horizon and forecasts against this forward yield curve.
4.2 Discrete Forward Rate and the Instantaneous Forward

Curve
Based on the definition of the discount factor d in (2.1.3), we define the discount
factor dk starting with by t0 ¼ 0.
1
dk ¼ dk ðrðtk Þ; tk Þ ¼ :
ð1 þ sðtk ÞÞtk
Thus, we have by (4.1.5)
1
dk 1 þ 0 h 1 0 f 1 : 1 þ 1 h 2 1 f 2 : . . . . . . : : 1 þ k1 hk k1 f k
¼ ,
1
dk1 1 þ 0 h 1 0 f 1 : 1 þ 1 h 2 1 f 2 : . . . . . . : : 1 þ k2 hk1 k-2 f k-1
i.e., we have
1
dk
1
1 ¼ k1 hk k1 f k :
dk1
We find the marginal increase of the discount factor over the time is
dk1 dk
¼ k1 hk k1 f k :
dk
We define the instantaneous forward rate f(t), t ∈ [0, T], by
∂dðtÞ
∂t
f ðtÞ ¼ : ð4:2:1Þ
dðtÞ
A function is called continuous if the function has no jumps, i.e., if the originals
of a function are closed together, the images are also closed together. A step
function is a function that is piecewise constant. For a typical example, we refer
to (4.1.4) as we have
f ðtÞ ¼ k1 f k , t ∈ ½tk1 ; t, k ¼ 1, . . . : : , N:
The precise definition of a continuous function is in [3].
Theorem 4.1 Assume that the forward continuous rate f(t) of the interval [0, T] is
annual. Then, for tB, tE with tE > tB and tB ∈ [0, T], tE ∈ [0, T], and continuous
compounding forward rates, we have for the spot rate s(t)
0 1 0 1
ðtE ðtE 0
1@ 1 d ð t Þ
sðtE Þ ¼ tB sðtB Þ f ðτÞdτA ¼ @tB sðtB Þ dτA, ð4:2:2aÞ
tE tE dðtÞ
tB tB
and the effective spot return efs is
ÐtA
f ðtÞdt
efs ¼ etB 1: ð4:2:2bÞ
Proof We consider (4.1.4b) with tB ¼ t0 and tE ¼ tN
etE sE ðtÞtB sB ðtÞ ¼ e0 t 1 f 1 ðtÞþ:...þk t k1 f k ðtÞþ:...þN1 tN f N ðtÞ : ð4:2:3Þ
We introduce two step functions. With
m k ðf Þ ¼ min f ðtÞ, Mk ðf Þ ¼ max f ðtÞ,

t ∈ ½tk ;tkþ1 t ∈ ½tk ;tkþ1
and we approximate
X
N ðtB X
N
k f kþ1 mk ðf Þ f ðτÞdτ k f kþ1 M k ðf Þ

k¼1 k¼1
tA
by a lower, upper, resp. approximation of f. By applying the rules of the logarithm,

we find
4.2 Discrete Forward Rate and the Instantaneous Forward Curve 109
X
N ðtB X
N
k f kþ1 mk ðf Þ f ðτÞdτ k f kþ1 M k ðf Þ

k¼1 k¼1
tA
by considering the definition of the integral (see Appendix E). □
Corollary 4.1 Assume that the forward rates f(t) of the interval [0, T] are annual
and continuous. Then, for continuous compounding forward rates, we have for the
spot rate s(t)
ðT ðT ∂dðtÞ
1 1 ∂t dτ,
s ð TÞ ¼ f ðτÞdτ ¼
T T dðtÞ
0 0
and the effective spot return efs is
ÐT
f ðtÞdt
efs ¼ e 0 1:
Proof The proof follows from Theorem 4.1 by tB ¼ 0 and tE ¼ T. □
Example 4.3 (Annual Versus Continuous Compounding) We assume four

equidistant knots (1) with T ¼ 4, and the unit of the time axis is years. We consider
an initial investment of $100, and the spot curve is
0 s1 ¼ 2% on ½0; 1Þ, 1 f 2 ¼ 3% on ½1; 2Þ and 2 f 3 ¼ 4% on ½2; 3Þ:
By using continuous compounding, the ending value EV 1 is
EV1 ¼ BV e0:09 ¼ BV e0:02 e0:03 e0:04 :
EV1 ¼ $1:094174,
and annually we have
EV1 ¼ ð1 þ 0:02Þ ð1 þ 0:03Þ ð1 þ 0:04Þ:
EV3 ¼ $1:092624:
Nelson-Siegel and its extensions is a very popular method for fitting yield
curves. It is widely discussed in the literature (see, e.g., [1, 2]). We only use it
here for illustrating Theorem 4.1.
Example 4.4 (Nelson-Siegel) Starting point of the Nelson-Siegel model is a

functional form of the annualized forward curve with three parameters β1 ∈ R1,
β2 ∈ R1, and β3 ∈ R1:
ht i
f ðtÞ ¼ β1 þ β2 eλ β3 eλ , λ ∈ R1 :
t t
λ
Thus, we have
f ð 0 Þ ¼ β1 þ β 2 :
We consider the indefinite integral
ðy ðy ðy
β1 1 dx þ β2 e dx þ β3 xex dx ¼ β0 þ β1 y ðβ2 þ β3 Þey β3 yey
x
and define the annualized spot curve by
β0 þ β1 y ðβ2 þ β3 Þey β3 yey

sðyÞ ¼ : ð4:2:4Þ
y
By choosing
β0 ¼ β 2 þ β 3 ,
the singularity is removable, and we have
β1 y þ ðβ2 þ β3 Þð1 ey Þ β3 yey

lim sðyÞ ¼ ¼ β1 β3 :
y!0 y
Thus, we have
ðβ2 þ β3 Þð1 ey Þ

s ð y Þ ¼ β1 þ β3 ey :
y
We consider the time scaling
t
y¼ ,
λ
and the spot rate (4), by exchanging the variable t by y, is
4.3 Spot Rate and Yield Curve 111
1 e λ
t
β3 eλ , λ ∈ R1 ,
t
sðtÞ ¼ β1 þ ðβ2 þ β3 Þ t ð4:2:5Þ
λ
and we have
s ð 0 Þ ¼ β1 þ β 3 :
4.3 Spot Rate and Yield Curve
Definition 4.5 The notion term structure refers to the distribution of any rates
along the time axes. The term structure of the par yield rates is called the par yield
rate curve.
The par bond rate curve is representative for the value of a coupon the bond
universe in paying at each point of the axis. Starting with a given spot curve s(t),
we derive in this section a par yield curve.
Theorem 4.2 We assume that the spot curve s(t) and the discount factor d(t) are
continuous and expressed in years. The par yield rpar of a bond with time to maturity
tN ¼ T at t ¼ 0 is then given by discrete compounding
1 d N ð TÞ
rpar ðTÞ ¼ ð4:3:1aÞ
PN
d ðtk Þ
k¼1
and by continuous compounding
1 es N T
rpar ðTÞ ¼ : ð4:3:1bÞ
PN
s k
ek
k¼1
Proof We start by (3.1.1) by evaluation at t0 ¼ 0:
X
N
C 1
Pð0Þ ¼ þ :
j¼1 ð1 þ rÞj ð1 þ rÞN
By using the assumption that the spot rate is given by
X
N
C 1
Pð0Þ ¼ j þ ,
j¼1 1 þ s tj ð1 þ sðt N ÞÞN
for a bond at par, we have
Pðt0 Þ ¼ 1 and C ¼ rpar ,
and thus, for annual compounding, we have
X
N
rpar 1
1¼ j þ ,
j¼1 1 þ s tj ð 1 þ s ðtN ÞÞN
and, by continuous compounding and (3.1.4), we have
X
N
1¼ rpar ejsðtj Þ þ eNsðtN Þ ,
j¼1
which yields (1). □

The government bond markets of some developed countries, for example, the USA,
the UK, Japan, or Switzerland, are the least likely to default. These governments
will pay a minimum of borrowing costs. The US government is and has been the
most important bond market globally. It has been best populated in terms of time to
maturities of individually bonds. Often it is said that these markets are riskless. An
investor who holds the bond until maturity has no interest rate risk, because he gets
his investment back at the time of maturity. However, an investor that trades its
positions in the portfolio is exposed to the interest market risk. We proceed with a
general definition of market risk:
Definition 4.6 The term market risk reflects to the possibility that an investor
experiences losses due to factors that affect the overall performance of financial
markets.
Remark 4.3 Examples for market risk are natural disaster, recession, political
turmoil, changes in interest rates, and terrorist attacks.
Remark 4.4 The interest rate market risk is the market risk affecting the yield
curve, regardless of the risk originating from specific issuer of fixed income
instrument. The inflation and money market policy of central banks are typical
market risks for interest rates. There are also theories that try to explain the behavior
of the interest rates (see, e.g., [1]). The market price of a bond is exposed to interest
rate market risk, the coupon payment, and the face value, and however is
untouched. Thus, in economic research, market prices are important for assessing
interest rate market.
The spot rate curve can be used as a benchmark for pricing bonds. This type of
rate curve can be built from on-the-run treasuries. In Theorem 4.2, we derive the par
yield curve from the spot rate. As bond prices are traded in the market place, the
question is rather:
How can yields to maturities be transformed in spot rates?
Lemma 4.1 (Linear Structure of the Bond) A bond is equal to a series of zero
coupon bonds.
Proof Follow from Definition 4.7 and the price formula of the invoice price
(3.1.2). □
We measure the bond price in the market, and we assume that we know the term
and condition of the bond. With Bootstrapping, we describe the transition with
which the spot curve and the forward rates are calculated from the bond price and
the coupon. Bootstrapping makes the very restrictive assumption that we have a
price at each point. We assume that the price PN and the coupon CN and time tN of
the bond are given. We proceed iteratively and consider a bond that matures in
1 year,
C1 þ F1
P1 ¼ , ð4:3:2aÞ
1 þ s1
i.e.,
C 1 þ F1
s1 ¼ 1: ð4:3:2bÞ
P1
For two periods, we have
C2 C2 þ 100
P2 ¼ þ ,
1 þ s1 ð1 þ s2 Þ2
i.e.,
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
C2 þ 100
s2 ¼ 1,
P2 1þs C2
1
CN CN CN þ FN
PN ¼ þ ...... þ þ :
1 þ s1 ð1 þ sN1 Þ N1
ð1 þ sN ÞN
We proceed with illustrating that the only yield curve that is equal to the spot
curve is the par yield.
The following example shows that two par bonds with different par yields
exemplify the general case, i.e., the yield of the maturity in the first interval is
equal to the spot rate, and the second spot rate is numerically different to the par
yield:
Example 4.5 We consider a par bond with 1-year maturity with a coupon
C1 ¼ 10% and a par bond with 2-year maturity with a coupon C2 ¼ 10%. For the
spot curve, we have
F1 þ C1
s1 ¼ 1 ¼ 10%
P1
and
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
F þ C2
s2 ¼ 1¼
P2 1þs C2
1
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
100% þ 10%
1 ¼ 1:1 1 ¼ 0:1, s2 ¼ 10%,
100% 10% 1:1
Thus, the 2-year spot is equal to the yield to maturity. In the following, we
illustrate that if the par yield of the 2-year par yield is different to 1-year par yield,
then the 2-year spot yield is different to the par yield of the 2-year bond. We
consider par yields between 0% and 20%, and Fig. 4.3 shows the par yield of the
2-year bond versus the difference of the par yield 2-year spot and the 2-year spot
rate. If the coupon is zero, we find s2 ¼ 0. We see that the spot rate is bigger than the
par yield if the par yield is smaller than s1, and that the spot rate is smaller than the
par yield if the par yield is bigger than s1. The par yields are averaging the spot
rates.
The question is whether a par bond can be replaced by a bond with the same
yield of maturity leaving the spot rate unchanged. The following example shows
that this is in general not the case:
Example 4.6 We consider a par bond with 1-year maturity with a coupon
C1 ¼ 10% and a par bond with 2-year maturity with a coupon C2. We distinguish
two cases:
0.20%
0.00%
0.00% 5.00% 10.00% 15.00% 20.00%
-0.20%
par - spot
-0.40%
-0.60%
-0.80%
-1.00%
-1.20%
Coupon
Fig. 4.3 Par versus spot

16.0%
15.8%
15.6%
15.4%
s2
15.2%
15.0%
14.8%
14.6%
-5% 0% 5% 10% 15% 20% 25% 30% 35%
C2
Fig. 4.4 Same yield to maturity versus different coupons
(a) C2 ¼ 10%. By changing the C2 and the price of the bond with 2 years to
maturity such the yield to maturity is equal to 10%, an analysis shows that
s2 ¼ C2 ¼ 10%.
(b) C2 ¼ 15% + α%, α ∈ Z, 20 α 20. Figure 4.4 shows the spot rate s2 as a
function of the coupon C2. We keep the yield to maturity 15% constant, i.e.,
we consider non-par yield. If the coupon is zero, we have a second zero
coupon. The analysis of the formulae shows that the difference is an almost
linear relationship, and the par yield is unique in the sense that the spot rate
changes by exchanging a bond with the same time to maturity and the same
yield to maturity.
The following formula computes recursively the spot rate sn:

vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u Ck þ Fk
sk ¼ u
u
k
kP
1, 1 k N:
t 1
Pk Ck 1
ð1þsn Þn
n¼1
This leads to the following theorem:
Theorem 4.3 (Bootstrapping) We consider a portfolio that consists of a series of

par straight bonds Pk with face Fk and coupons Ck that have time to maturities
Tk ¼ k, 1 k N
and coupon payments at
Tk ¼ j, 1 j k, 1 k N:
We consider a flat curve with interest rate r ∈ R1 and assume that

X
k1
1
Pk > Ck 1, 1 k N:
n¼1
ð 1 þ sn Þn
Then, there exits an interval Iδ(rr) such that for each rk ∈ R1 in Iδ(rk) with price
Pk(rk), starting with s1 ¼ r1, the spot rates sk and 2 k N are recursively given by
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u Ck þ Fk
sk ¼ u
u
k
kP
1, 1 k N: ð4:3:3Þ
t 1
Pk Ck 1
ð1þsn Þn
n¼1
Proof We consider a series of bonds Bk, 2 k N, with prices and face value,
resp., as
PN ¼ 100%, FN ¼ 100%, N ¼ 1, : . . . , resp:, ð4:3:4aÞ
and coupons
1 r ¼ C, 1 k N: ð4:3:4bÞ
Then the yield of maturities rN of the bonds BN satisfies
(a) rN ¼ 100
C
, N ¼ 1, . . . :
(b) sN ¼ 100 , N ¼ 1, . . . :
C
We pursue a proof by induction. For N ¼ 1, the assertion follows from (1).

By hypothesis of the theorem, we start by
PN ¼ 100, N ¼ 1, . . . :
(a) By considering the equation for the yield of the maturity r, we have
CNþ1 CNþ1 CNþ1 þ FNþ1

PNþ1 ðrÞ ¼ þ þ ... þ
1 þ r ð1 þ rÞ 2
ð1 þ rÞNþ1
!
1 CNþ1 CNþ1 þ FNþ1
¼ CNþ1 þ þ ... þ :
1þr 1þr ð1 þ rÞN
By substituting r ¼ rN and using (4),
1
PNþ1 ðrN Þ ¼ ðC þ PðrN ÞÞ, N ¼ 1, . . . : ,
1 þ rN
i.e.,
1
PNþ1 ðrN Þ ¼ ðC þ PðrN ÞÞ,
1 þ rN
and defining
C
rNþ1 ¼ rN ¼ ,
100
we find that rN+1 satisfies
1
PNþ1 ðrNþ1 Þ ¼ ðC þ PðrNþ1 ÞÞ ¼ 100,
1 þ rNþ1
i.e., rN+1 is the yield of maturity of PN+1.
(b) We start by (3) and (4), and we use the induction assumption
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u CþF
u
¼ Nþ1 1, 1 k N:
sNþ1 u
t PN
PNþ1 C
ð1þCÞk
k¼1
Following (a), rN+1 is the yield of maturity from PN+1
C C C CþF
PNþ1 ðrNþ1 Þ þ þ ... þ ¼ :
1 þ rNþ1 ð1 þ rNþ1 Þ 2
ð1 þ rNþ1 Þ N
ð1 þ rNþ1 ÞNþ1
ð4:3:5Þ
Thus, we find
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u CþF
u
¼ Nþ1 1, 1 n N,
sNþ1 u
t PN
PNþ1 C
ð1þCÞk
k¼1
and thus, we have rN+1 ¼ rN ¼ C and

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
CþF
sNþ1 ¼ Nþ1
FþC
1, 1 n N,
ð1þCÞNþ1
i.e.,
sNþ1 ¼ C, 1 n N:
□
Remark 4.5 As exposed in [4], we consider

0 1 0 1
1 þ r1 0 0 0 0 P1
B : 0 0 0 0 C B C
B C B C
A¼B
B rj : 1 þ rj 0 0 C B C
C, P ¼ B Pj C:
@ : : : 0 0 A @ A
rn : : : 1 þ rn Pn
Then, the system of linear equations
Ad ¼ P
for the discount factors

0 1
d1
B C
B C
d¼B C
B dj C
@ A
dj
is the same as evaluating the recursive formula (3).
Remark 4.6 The yield to maturity of a bond is not used in (3) and can be calculated
by price, coupon, and time to maturity of the bond.
The spot curve allows pricing a bond universe consistently.
Example 4.7 We consider bonds where the coupon is equal the yield to maturity
Ck
rk ¼ ¼ k, 1 k 10, ð4:3:6Þ
100
i.e., according to Lemma 4.1, we have Pk ¼ 100. The values in Table 4.1 are
calculated by formula (3).
The ending spot rate is above the yield to maturity. In addition, the difference
between consecutive spot rates is increasing. In general, the spot curve has to be
modelled from many bonds. The problem is underdetermined. The spot curve is
then estimated by a few numbers of parameters and a functional form of the term
functional.
Table 4.1 Calculation by bootstrapping

Time tk t¼1 t¼2 t¼3 t¼4 t¼5
Spot rate 0.0100 0.0201 0.0304 0.0411 0.0522
Time tk t¼6 t¼7 t¼8 t¼9 t ¼ 10
Spot rate 0.0640 0.0760 0.0910 0.1074 0.1270
Fig. 4.5 Spot rates for 1 to 0.14

10 years to maturity
0.12
0.10
0.08
0.06
0.04
0.02
0.00
0 2 4 6 8 10
Table 4.2 Step function

Time span 0<t 1 1<t2 2<t3 3<t4 4<t5
Spot rate 0.0100 0.0201 0.0304 0.0411 0.0522
Time span 5<t6 6<t7 7<t8 8<t9 9 < t 10
Spot rate 0.0640 0.0760 0.0910 0.1074 0.1270
However, we have only points in time. For Fig. 4.5, we expand the spot rate to
the time axis between 0 and 10 years by a piecewise constant function. The values
for any time are in Table 4.2.
In mathematical terms, the function is not continuous and has jumps at the time
t ¼ 1, . . . , 10. The function is called left sided continuous.
The Bootstrapping has the following two properties:
1. It makes the assumption that we have a price at each coupon payment.

2. There is no parameter specification like in the Nelson-Siegel.
Example 4.8 (Discount Factor) We investigate the discount factor under different
interest rate term structures. We look at time from 1 to 10 years. We see that the
normal and the flat curve have a decreasing discount factor, but the inverse curve
has a minimum and is not monotonically decreasing or increasing (see Figs. 4.6,
4.7, and 4.8).
An Example of a Twice-Differentiable Continuous Representation of the Spot

Curve: The McCulloch Equations
In order to estimate the discount function
t
1
dð t Þ ¼
1 þ sðtÞ
from the observed prices of N bonds, the discount function is written as a linear
function of basis function
0.12
0.10
0.08
C=2%
Present Value 0.06 C=4%
C=6%
0.04 C=8%
C=10%
0.02
0.00
0 2 4 6 8 10
time
Fig. 4.6 Normal curve
0.10
0.09
0.08
0.07
0.06 C=2%
Present Value 0.05 C=4%
0.04 C=6%
0.03 C=8%
0.02
C=10%
0.01
0.00
0 2 4 6 8 10
time
Fig. 4.7 Inverse Curve
X
M
dðtÞ ¼ 1 þ λm f m ðtÞ ð4:3:7Þ
m¼1
where fm(t) is the mth basis function and λm, m ¼ 1, . . . , M are the corresponding
coefficients. The discount factor (see Definition 2.1) in the time point tk is
0.10
0.09
0.08
0.07
0.06 C=2%
Present value 0.05 C=4%
0.04 C=0.6%
0.03 C=8%
0.02 C=10%
0.01
0.00
0 2 4 6 8 10
time
Fig. 4.8 Flat curve with 5%
tk
1
dk ¼ dð t k Þ ¼ :
1 þ sðtk Þ
The invoice price of a Bond j is then
X
Tj
IPj ¼ ck dk þ FTj dTj , j ¼ 1, . . . : , N:
k¼1
By (6) we have
! !
X
Tj X
M X
M
IPj ¼ ck 1 þ λm f m ðdk Þ þ FT j 1 þ λm f m ð d T J Þ ,
k¼1 m¼1 m¼1
i.e.,
X
Tj X
Tj X
M X
M
IPj ck FTj ¼ ck λm f m ðdk Þ þ FTj λm f m ðdTJ Þ:
k¼1 k¼1 m¼1 m¼1
Hence,
X
Tj Tj X
X M X
M
IPj ck FTj ¼ ck λm f m ðdk Þ þ FTj λm f m ðdTJ Þ:
k¼1 k¼1 m¼1 m¼1
By arranging the sum, we have
X
Tj X
M X
Tj X
M
IPj ck FTj ¼ ck λn f n ðdk Þ þ FTj λm f m ðdTJ Þ,
k¼1 m¼1 k¼1 m¼1
i.e.,
! !
X
Tj X
M X
Tj
IPj c k FT j ¼ λn c k f m ð dk Þ þ FT j f m ð d T J Þ :
k¼1 m¼1 k¼1
With the matrix

2 3
a1, 1 a1, M
A¼4 ⋮ ⋱ ⋮ 5,
aN, 1 aN , M
where
!
X
Tj
ajm ¼ c k f m ð dk Þ þ FTj f m ðdTJ Þ,
k¼1
and
3 2
b1
6 : 7
6 7
b¼6 7
6 : 7,
4 : 5
bN
where
X
Tj
bj ¼ IPj c k FT j :
k¼1
We solve the linear equation
Aλ ¼ b:
This equation can be solved if M ¼ N. But if we want to describe the Bond with
less parameters, we have to consider the least quadrat approximation
AT Aλ ¼ AT b:
We proceed to consider a McCulloch’s cubic spline specification starting with

the partition
tk , 0 k N,
where t0 ¼ 0 and tN denotes the bond of the longest time to maturity. We define,
for t < tk1,
f k ðtÞ ¼ 0, ð4:3:8aÞ
and, for tk1 t < tk,
ðt tk 1 Þ3
f k ðtÞ ¼ , ð4:3:8bÞ
6ðtk tk 1 Þ
and, for tk t < tk+1,
c2 ce e2 e3
f k ðtÞ ¼ þ þ , ð4:3:8cÞ
6 2 2 6ðtkþ1 tk Þ
where
c ¼ tj tk1 ,
e ¼ t tk ,
and, for tk+1 t,

2tkþ1 tk tk1 t tkþ1

f k ðtÞ ¼ ðtkþ1 tk1 Þ þ ð4:3:8dÞ
6 2
and, when j ¼ k,
f j ðtÞ ¼ t: ð4:3:8eÞ
In Appendix I, is it shown that the spline function above a twice differentiable

and in picture and in Fig. 4.9 we evaluation of (8).
We see that the last piece of the spline function begins with the function value
1 and has slope 1. We evaluate the index in (8d) for equidistant knots and find
2tkþ1 tk tk1 ¼ 3:
Example 4.9 (Flat Yield Curve) We consider a portfolio with two par bonds with
yield to maturities of 3% and invoice prices IPj. For j ¼ 1, 2, we have
6.00
5.00
Basis 1
4.00
Basis 2
3.00
Basis 3
2.00
Basis 4
1.00
Basis 5
0.00
0.00 1.00 2.00 3.00 4.00 5.00 6.00
Fig. 4.9 Base functions
! !
X
Tj X
2 X
2
IPj ¼ ck 1 þ λ m f m ð dk Þ þ FTj 1 þ λm f m ðdTJ Þ :
k¼1 m¼1 m¼1
This is the same as
X
Tj X
2 X
Tj
IPj ¼ c k FT j ¼ λn ck f m ðdk Þ þ FTj f m ðdTJ Þ:
k¼1 m¼1 k¼1
We consider two basis functions on three equidistant knots. We have

*3
t
, t ∈ ½0; 1
f1 ¼ 6
t t 1 ðt 1Þ2 ðt 1Þ3
þ þ , t ∈ ½1; 2
6 2 2 6
and f2 ¼ t, t ∈ [0, 2].

1:03 0
B¼
0:03 1:03
and
* +
1
C¼ 1
6
1 2
Furthermore we have

0:1717 1:030
A ¼ BC ¼ ð4:3:11aÞ
1:0350 2:090
and

P 1 F1 C 1
b¼ ð4:3:11bÞ
P2 C2 F1 C1
yields

0:0300
b¼ :
0:0600
With (11), we solve
Aλ ¼ b
for the vector λ ¼ (λ1, λ2). Figure 4.10 shows the discount factor (7) with the
numerical values
dð1Þ ¼ 0:9709
dð2Þ ¼ 0:9426:
As expected, the calculation yields 3% by construction for the spot rate 3% at

time 1 and 2.
1.01
1.00
0.99
0.98
0.97
0.96
0.95
0.94
0.93
0 0.5 1 1.5 2 2.5
Fig. 4.10 Discount factor

In this section, we discuss some aspects from what is called yield curve
modelling. The interpolation of points in the plane is a problem that is extensively
studied in mathematics. The question is how the points are fitted by a real valued
function that is defined by a continuous real variable. Although basic, linear
interpolation is often used (see Appendix F). The choice of the function has to be
based on the information already known from the underlying problem. For instance,
in [5], periodic function is used for interpolating because the underlying problem is
periodic. For yield curve modelling, we have information on a finite interval in R1.
By the McCulloch equation, a spline function has been chosen. In order to have
smoothness, the spline functions are chosen to be twice differentiable (see Appen-
dix I). In (7), the discount function is approximated by a set of basis function.
Figure 4.4 suggests that a yield curve that is increasing, decreasing, or flat lies under
the bond prices.
In the literature (see, e.g., [1]), different base functions like (7) are investigated.
There is a trade-off in curve fitting between smoothness and the goddess of the fit
of the yield curve estimations. It is important to strike a balance between those
models that are too flexible and fitting the data and treating outliner as the norm and
those models that are too parsimonious with the parameters used. In the literature,
parameter and non-parameter fitting models are distinguished. Nelson-Siegel and
its extensions with their few parameters are examples of a parameter model, and the
fitting curve using spline is an example of a non-parameter model.
Figure 4.1 refers to a point in time, and curve fitting is concerned with fitting the
yield curve, the spot curve, and the forward curve. Thus this is a static consideration
and a second type of interest model is considering the dynamic of the interest rates.
They incorporate the volatility of the interest rate. We distinguished between
equilibrium term structure model and arbitrary model. Contrary to yield curve
model, they are not only applicable to straight bonds but can also be used to, e.g.,
callable or convertible bonds (see Appendix K). They are based on a random walk
for asset pricing and investigate relative asset pricing by stochastic differentiable
equations. Essentially we have a paradox. Arbitrage situations are examined
although they should not exist according to the equilibrium theory. An overview
of equilibrium term structure models is in [2].
4.4 The Effective Duration
As discussed, in Sect. 3.4.4, the Macaulay duration (3.4.49) can be calculated with
different arguments assuming that every cash flow is discounted with the same
interest or the yield to maturity of each bond in (3.3.1). In the following,
we generalize the Macaulay duration by introducing the Fisher-Weil duration. If
the yield curve is flat, the Fisher-Weil duration is equal to the Macaulay duration.
If the yield curve is not flat, the value for the Fisher-Weil duration is different from
the values for the Macaulay duration.
Definition 4.7 We consider a straight bond and assume that the spot curve is given.
The Fisher-Weil duration of a bond is defined by
4.4 The Effective Duration 127
P
N
ðj 1 þ αÞ C
þ ðn 1 þ αÞð1 F
ð1 þ sðtj ÞÞ þ sðtN ÞÞN1þα
j1þα
j¼1
DFij We ðrÞ ¼ :
P
N
C
þ F
ð1 þ sðtj ÞÞ ð1 þ sðtN ÞÞN1þα
j1þα
j¼1
The effective duration is a first generalization of the flat curve concept. In the flat
curve concept, it is assumed that the prices of the bonds are known. If the cash flow
of a bond changes when interest are changing, valuation models based on the spot
curves are needed.
In the following Definition, we consider the spot rate and the effective duration
can be seen as generalization of the modified duration. We consider the invoice
price (3.1.2) of and bond
1 XN
C F
IPðtÞ ¼ t1 t j þ , t ∈ ½t0 ; t1 ,
ð1 þ s0 Þ j¼1 1 þ sj ð1 þ sN ÞN
and, by using the flat price, we have
1 XN
C F
PðtÞ þ ð1 αÞC ¼ t1 t j þ t ∈ ½t0 ; t1 :
ð1 þ s0 Þ j¼1 1 þ sj ð1 þ sN ÞN
We consider a constant shift f scaled by h
1 XN
C F
Pðt; hÞ þ ð1 αÞC ¼ t1 t j þ
ð1 þ s0 þ hf Þ j¼1 1 þ sj þ hf ð1 þ sN þ hf ÞN
and proceed by the following definition:
Definition 4.8 (Effective Duration Relative to a Constant Shift) We consider the

continuous

∂Pðsðhf ÞÞ
j ∂h h¼0
Deff ðr Þ ¼
IP
and the discrete version
PðsðτÞþhÞ
j Pðsð2h
τÞhÞ
DDeff ðr Þ ¼ 2h
IP
of the effective duration.
Remark 4.7 The calculation of the effective duration uses the theoretical prices of
the bonds.
The effective duration is also called the option-adjusted duration because it
allows to respect the different time to maturity when interest rates are moving. We
conclude with the following lemma and leave the verification to the reader:
Lemma 4.2 The Fisher-Weil duration and the effective duration are linear, i.e., the
Fisher-Weil duration and the effective duration of a portfolio are equal to the asset
price weighted of the Fisher-Weil duration and the effective duration, respectively.
References
1. Nicola A, Francis B, Mark D, Andrew D, Gareth M (1997) Estimating and interpreting the yield
curve. Wiley, Chichester
2. Moorad C (2004) Analyzing and interpreting the yield curve. Wiley, Singapore
3. Christian B (1974) Analysis I, II, III. Springer, Berlin
4. Walter G, Ludger O (1998) Nie mehr Bootstrapping. Schweizerische Gesellschaft für
Finanzforschung Finanzmarkt und Portfolio Management, Luzern, pp 59–73
5. Marty Wolfgang (2009) A Newton-Raphson method for numerically constructing invariant
curves. Dissertation, University of Zurich
Spread Analysis
5
5.1 Interest Rate Spread
In this chapter, we depart from bonds that are considered as riskless. Riskless in this
context here means that the investor
• receives his initial capital back at the time to maturity:

ð5:1:1Þ
• gets periodically coupon payments
They are described in the previous sections. Traditionally, government bond is

said to be riskless. For instance, the treasury bond of the US Government or the
government bonds called Eidgenossen from Switzerland are an example for riskless
bonds.
We proceed with the following definition:
Definition 5.1 A corporate bond is a debt security issued by a corporation and sold
to investors. The backing for the bond is usually the payment ability of the
company, which is typically money to be earned from future operations. In some
cases, the company’s physical assets may be used as collateral for bonds.
Corporate bonds are often considered as an investment which bears higher risk
than government bonds. As a result, the yield to maturity of a corporate bond is in
most cases higher that the yield to maturity of a similar government bond. In other
words, the investor is recompensed by investing in a corporate bond instead in a
government bond. However, with the deterioration of the creditworthiness of
Greece and Italian government bonds, Figs. 5.1 and 5.2 show that government
bonds can have higher yields than corporate bonds. In Fig. 5.1, we show a
substantially increase of the difference between the yield to maturity (YTM) of
the Greece government bond versus the YTM of Coca-Cola Hellenic Bottling
Bond. After this time of span shown in Fig. 5.1, there were no prices available
for the private investor.

130 5 Spread Analysis
50
45
40
35
30
YTM
25 Corporate
20 Government
15
10
0
04.01.2010
0 - 02.01.2012
2
Fig. 5.1 Greece government bond
6.0
5.0
4.0
YTM
3.0 Corporate
Government
2.0
1.0
0.0
30.07.2012- 1.09.2014
Fig. 5.2 Italian government bond
In Fig. 5.2, we show a time span in which the YTM of the covered bond der
Banca Intesa San Paolo tends to the YTM of an Italian government bond. However,
the difference between the YTMs of the two bonds is increasing again afterward.
The yield to maturity constitutes of two parts, and we need the following two
definitions:
Definition 5.2 (Spread) An interest rate spread is a general term for differences of
interest rates.
Definition 5.3 (Nominal Interest Rate Spread) The spread of a bond refers to the
yield enhancement over a government bond with similar time to maturity. More
specifically, this spread, denoted by cs, is called the nominal interest spread.
5.1 Interest Rate Spread 131
Assuming that the price of a bond is known and the yield curve of the universe of
the riskless bonds is known, the nominal spread is the difference of the yield to
maturities. Thus, we consider the decomposition of the yield to maturity rT in a risk
less interest rate r and a credit spread cs as
rT ¼ r þ cs:
Remark 5.1 The bonds in the portfolio considered in Example 3.13 can be
described by nominal spreads. Assuming that the bond with the lowest yield is
considered as riskless, the other two bonds have credit spreads cs ¼ α and cs ¼ 2α,
respectively.
The following definition is based on the spot curve.
Definition 5.4 (Interest Z-Spread) The Z-spread of a bond is the spread that
shifts the spot curve such that the price of the bond is matched.
Example 5.1 We assume a normal spot curve with
sk ¼ k, k ¼ 1, . . . :, 10, ð5:1:2aÞ
a flat spot rate curve
sk ¼ 5, k ¼ 1, . . . :, 10, ð5:1:2bÞ
and an inverse spot rate curve
sk ¼ 10 k, k ¼ 0, . . . :, 9: ð5:1:2cÞ
We consider the three par bond calculating spot rates (2). The basis for the
nominal spread is the yield to maturity of the par bond. We consider three different
credit bonds with Z-spreads 100, 150, and 200 bps. They pay annually coupons and
have a maturity of T ¼ 10 years. We show in Table 5.1 the nominal spread as a
function of the Z-spreads and the form of the spot curves (2). The yield to maturity
is calculated by the price of the credit bond based on the spot rates (2) and the
Z-spread.
Table 5.1 Z-spread Nominal spread

versus nominal spread
Z-spread Normal Flat Inverse
100 95 100 101
150 142 150 151
200 190 200 202
We continue with the following definition:
Definition 5.5 (Spread Duration) The spread duration measures the sensitivity of
the price of a bond with respect to the spread above the riskless yield curve.
We have the following:
Lemma 5.1 Using the flat curve concept (Definition 3.6) and assuming a constant
nominal spread, the spread duration is equal to the modified duration of a straight
bond.
Proof The price of a straight bond is
X
N
C F
Pð r T Þ ¼ þ :
j¼1 ð1 þ r T Þ j
ð1 þ rT ÞN
The derivative (chain rules) gives
∂P 1 XN
C F
¼ þ ¼
∂r T ∂r j¼1 ð1 þ r þ csÞ ð1 þ r þ csÞN
j
1 X N
C F ∂P
þ ¼ :
∂cs j¼1 ð1 þ r þ csÞj ð1 þ r þ csÞN ∂cs
The assertion follows from the definition of the modified duration (3.1.17). □
We look at the difference
ΔrT ¼ Δr þ Δcs,
and with the discrete version for the modified duration (see Definition 3.18) and
Lemma 5.1, we have
j
ΔPðrÞ ¼ DDMod ðrÞPðrÞΔrT ¼
ð5:1:3Þ
j j
DDMod ðrÞPðrÞΔr DDMod ðrÞPðrÞΔcs:
This leads to the following Lemma:
Lemma 5.2 Assuming that the r is unchanged, i.e., Δr ¼ 0, we have that a

tightening of the spread leads to a decrease of the bond price, and a widening of
the spread leads to an increase of the bond price.
Proof We prove the case spread is tightening, and then the case of the spread
widening follows analogously. If the spread is tightening, from cs1 to cs2, we have
0 < cs2 < cs1, and with
5.2 Rating Scales 133
Δcs ¼ cs2 cs1 < 0,
we find by (3)
j j
ΔPðrÞ ¼ DDMod ðrÞPðrÞΔrT ¼ DDMod ðrÞPðrÞΔcs > 0:
We see that the bond price diminished. □
5.2 Rating Scales
Spreads can be measured in the interest market and the following concepts are more
future-oriented. We proceed with the following definition:
Definition 5.6 (Credit Risk) The danger or the risk that the issuer of a bond does
not materialize the obligation to the investor is called credit risk.
Remark 5.2 The adverse outcome for the investor is called a default of a bond.
Roughly said, default means that one of the conditions (1) is violated. Precise
definitions of default follow.
Definition 5.7 (Credit Rating) A credit rating is an assessment of the possibility

that a bond defaults.
The three most known and influenced international rating companies in the
financial industry are Standard and Poor’s Corporation (S&P), Moody’s, and
Fitch. We start with a brief description of these companies. For further information,
see [1]. All three are based in the USA and are nationally recognized statistical
rating organizations (NRSRO) designated by the US Securities and Exchange
Commission in 1975.
S&P traces its history back to 1860 with the publication by Henry Varnum Poor
of History of Railroads and Canals in the United States. This book compiled
comprehensive information about the financial and operational state of US railroad
companies. In 1868, Henry Varnum Poor established H.V. and H.W. Poor Co with
his son Henry William Poor. In 1906, Luther Lee Blake founded the Standard
Statistics Bureau, with the view of providing financial information on non-railroad
companies. In 1941, Poor’s Publishing and Standard Statistics merged to become
Standard & Poor’s Corp. In 1966, the company was acquired by “The McGraw-Hill
Companies,” extending McGraw-Hill into the field of financial information
services.
Moody’s was founded by John Moody in 1909. He produced manuals of
statistics related to stocks, bonds, and bond ratings. Following several decades of
ownership by Dun & Bradstreet, Moody’s Investors Service became a separate
company in 2000; Moody’s Corporation was established as a holding company.
Moody’s Analytics is a subsidiary of Moody’s Corporation established in 2007 to
focus on non-rating activities, separate from Moody’s Investors Service.
Fitch Rating was founded by John Knowles Fitch on December 24, 1914, in
New York City as the Fitch Publishing Company. Fitch Ratings is the smallest of
the “big three” NRSROs, covering a more limited share of the market than S&P and
Moody’s, though it has grown with acquisitions and frequently positions itself as a
“tie breaker” when the other two agencies have ratings similar, but not equal, in
scale.
In September 2011, Fitch Group announced the sale of Algorithmics (risk
analytics software) to IBM for $387 million. The deal was closed on October
21, 2011.
Since 2012, Fitch Group is majority owned by Hearst. Fitch Group is comprised
of Fitch Ratings, a global leader in credit ratings and research; Fitch Solutions, a
leading provider of credit market data, analytical tools, and risk services; BMI
Research, an independent provider of country risk and industry analysis
specializing in emerging and frontier markets; and Fitch Learning, a preeminent
training and professional development firm.
Tables 5.2, 5.3, and 5.4 show the rating scale of Moody’s, S&P, and Fitch. There
are a series of rating companies, like Scope or CRIF (Centrale Rischi Finanziari
Italiana), which are European based and adopt the rating of S&P. In Switzerland,
UBS AG, Credit Suisse, Zürcher Kantonalbank, Vontobel, and Fedafin provide
ratings. All rating companies use letter rating. S&P use + and for refinement of
the letter rating, and Moody’s uses numbers for further refinement.
Table 5.2 Investment grade

S&P Moody’s Fitch Summary description
AAA Aaa AAA Gilt edges, prime, maximum safety
AA+ Aa1 AA+ High grade, high-credit quality
AA Aa2 AA
AA Aa3 AA
A+ A1 A+ Upper medium grade
A A2 A
A A3 A
BBB+ Baa1 BBB+ Lower medium grade
BBB Baa2 BBB
BBB Baa3 BBB
Table 5.3 Speculative lower credit worthiness

BB+ Baa1 BB+ Low grade speculative
BB Baa2 BB
BB Baa3 BB
B B1 B High grade speculative
B2
B3
Table 5.4 Predominantly speculative substantial risk or in default

CCC+ CCC Caa CCC+ CCC Substantial risk, in poor standing
CC Ca CC May be in default, very speculative
C C C Extremely speculative
DDD
D DDD Default
Spreads are measured in the market, and ratings are opinions of credit analysts of
a rating provider. There is not a one-to-one relationship between spreads and
ratings. Often, it is argued that the ratings are lagging behind the ratings. However,
the research of Moody’s Analytics shows the spread widens with lower ratings.
Regulations have increased tremendously recently and regulation often impedes
the opinion behind a rating. An approval of a market regulator is clearly
strengthening the acceptance of a rating agency in the market.
In addition, we distinguish between solicited ratings and unsolicited rating.
Solicited ratings are ratings that are requested by an issuer or an investor, and the
rating agency is remunerated. Unsolicited ratings are produced by the initiative of
the rating agency. The question is whether a rating can or should be published or if
proprietary is often subject to lengthy discussion.
We proceed with an elementary one-step credit model. We consider three events
(see also [2]):
• Event A defined by the fact that the bond survives till the time t: p(t).
• Event B defined by the fact that the bond survives till the time and goes bankrupt
between t and Δ + t survives.
• A[B is a joint event. The bond survives until t (A) and goes bankrupt between
t and t + Δt (B). The probabilities of this joined event are the difference of the
two survival probabilities:
pðtÞ pðt þ ΔtÞ:
The conditional probability we want to calculate corresponds to the event:
pðtÞ pðt þ ΔtÞ

PðB=AÞ ¼ :
pðtÞ
Definition 5.8 The default intensity λ(t) is defined by
pðtÞ pðt þ ΔtÞ pðt þ ΔtÞ

λðtÞΔt ¼ ¼1 :
pð t Þ pðtÞ
By using the Taylor approximation (see Appendix C) up to order 1 with respect

to Δt, we have
pðt þ ΔtÞ ΔpðtÞ

1 ¼ þ OðtÞ,
pð t Þ pð t Þ
∂ pðtÞ
∂t
Δt
λðtÞΔt ¼ þ OðtÞ,
pð t Þ
and hence
d log pðtÞ
λðtÞ ¼ :
dt
Assuming that λ is time independent, i.e., λ(t) ¼ λ, we thus consider
ðT
pðTÞ ¼ exp λðtÞds,
0
and hence
pðTÞ ¼ expðλTÞ ¼ 1 λT þ oðTÞ: ð5:2:1Þ
Definition 5.9 (Recovery Rate) On default, the investor has a claim toward the
issuer of the bond he is invested in. Some fraction of the claim will eventually be
paid back. This fraction, denoted by R, is called recovery rate and is expressed in
percentages (Fig. 5.3).
Remark 5.3 Recovery rates are rated by S&P, Fitch, and CRIF.
The default intensity model survival for a zero coupon over one period:
1
PðtÞ ¼ ðp þ ð1 pÞRÞ:
ð1 þ r ÞT
Fig. 5.3 One period credit

model Face Value F plus Accrued Interest A.I.
Price P
Default R*(F + A.I.)

By (1), we have
1 1
PðtÞ ¼ ðp þ ð1 pÞRÞ ¼ ð1 λT þ λTR þ oðTÞÞ,
ð1 þ rÞT ð1 þ rÞT
and by Taylor development leads to
PðtÞ ¼ 1 λT þ λTR rT þ oðTÞ: ð5:2:2Þ
The price of the zero bonds is
1
PðtÞ ¼ ¼ 1 rT cs T þ oðTÞ
ð1 þ ðr þ csÞÞT
and by (2) we have
1 rT csT ¼ 1 λT þ λTR rT þ oðTÞ,
And thus
cs ¼ λ λR þ oð1Þ,
and we proceed with the following definition:
Definition 5.10 The credit triangle is
cs
λ¼ :
1R
It is a relationship between the default intensity λ, the credit spread cs, and the
recovery rate R. The credit triangle is independent of the time and increases with the
spread. If the recovery rate increases, the default intensity will decrease.
Example 5.2 We consider an investment grade bond with a spread of 20 bps and a
recovery rate of 35%. Then default intensity amounts to 15.38%.
Not all the assets that can default are equally ranked. In the following, we see the
recovery rate of the asset that can default. In Table 5.5, we see the recovery rate for
bonds as a percentage of face value in the period of 1987–2014 (see Moody’s
Investors Service Annual Default and Recovery Rates, 1920–2015). There are
measured by post-default trading prices.
Table 5.5 Different seniorities

Recovery rate
Bond seniority Issuer-weighted (%) Volume-weighted (%)
First lien bond 53.4 53.4
Second lien bond 49.7 47.4
Senior unsecured 37.6 33.7
Senior subordinated 31.1 25.8
Subordinated 31.9 27.1
Junior subordinated 24.2 17.1
S&P defines default as follows [see annual S&P publication S@P Global Rating
RatingsDirect]: An obligor rated SD (selective default) or D is in payment default on one
of its financial obligations (rated or unrated) unless Standard & Poor’s believes that such
payments will be made within five business day in the absence of a stated grace period or
within the earlier of the stated grace period or 30 calendar dates. Standards and Poor’s also
lowers a rating to D upon an issuer’s filing for bankruptcy or taking a similar action that
jeopardizes payment on a financial obligation. A D rating is assigned when it believes that
the default will be a general default and that the obligor will fail to pay all or substantially
all of its obligations as they come due. Standard and Poor’s assigns an “SD” rating when it
believes that the obligor has selectively defaulted on a specific issue or class of obligations
but will continue to meet its payment obligations on other issues or classes of obligations in
a timely manner. A selective default includes the completion of a distressed exchange offer
whereby one or more financial obligation is either repurchased for an amount of cash or
replaced by other instrument having a total value that is less than par. “R” indicates that an
obligor is under regulatory supervision owing to its financial condition. This does neces-
sarily indicate a default event, but during the pendency of the regulatory supervision, the
regulators may have the power to favor one class of obligation over others or pay some
obligations over others or pay some obligations and other others. The preferred stock is not
considered a financial obligation; thus, a missed preferred stock dividend is not normally
equated with default.
S&P and Moody’s publish default statics in their annual reports. For an example,
we refer to Chart 5.1 (S&P Global Fixed Income Research) and Chart 5.2 (see
Moody’s Investors Service Annual Default and Recovery Rates, 1920–2014).
We proceed with the definition of default of Moody’s. It applies only to debt or debt-like
obligation (e.g., swap agreements) [see Publication Moody’s Investors Service Rating
Symbols and Definitions]. Four events constitute a debt under Moody’s definition:
1. A missed or delayed disbursement of a contractually obligated interest or principal

payment (excluding missing payment cured within a contractually allowed grace
period) as defined in credit agreement and indentures
2. A bankruptcy filing or legal receivership by the debt issuer or obligor that might likely
cause a miss or a delay in future contractually obligated debt service payments
3. A distressed exchange (see Remark 5.4) whether:
(a) An obligor offers creditor a new or restructured debt or a new package of securities,
cash, or assets that amounts to a diminished financial obligation to the original
obligation
(b) The exchange has the effort of allowing the obligor to avoid a bankruptcy or
payment default in the futures
Default rate in % to the sector
Utility
Insurance
High tech
Financial institutions
Transportation
Consumer/service sector
E&NR
0 1 2 3 4 5 6 7
1981-2015 weighted average 2015
Chart 5.1 Default rates of S&P. Source: S&P
2014 Default counts and volumes
Energy & Environment

Consumer Industries
Capital Industry
Banking
Transportation
Technology
Retails & Distribution
Non-Bank Finance
Media & Publishing
0 10 20 30 40 50 60 70
Counts in % Volume in %
Chart 5.2 Default rates of Moody’s. Source: Moody’s
4. A change in the payment terms of a credit agreement or indenture imposed by the

sovereign that results in a diminished financial obligation, such as forced currency
re-denomination (imposed by the debtor himself or his sovereign) or a forced change
in some other aspect of the original promise (e.g., indexation or maturity).
Remark 5.4 A distressed exchange means that the issuer pays the investor not by
money but by another asset of the company.
We proceed with the definition of default by Fitch: [see www.fitchratings.com/site/

definitions/internationalratings.html]
Fitch: differentiates between restricted default (RD) and default (D). RD ratings
indicate an issuer that in Fitch Ratings’ opinion has experienced an uncured payment
default on a bond, loan, or other material financial obligations but which has not entered
into bankruptcy filings, administration, receivership, liquidation, or other formal winding-
up procedures and which has not otherwise ceased operating. This would include (a) the
selective payment default on a specific class or currency of debt; (b) the uncured expiry of
any applicable grace period, cure period, or default forbearance period following a payment
default on a bank loan, capital market security, or other material financial obligations;
(c) the extension of multiple waivers or forbearance periods upon a payment default on one
or more material financial obligations, either in series or in parallel; or (d) execution of a
distressed debt exchange on one or more material financial obligations.
D ratings indicate an issuer that in Fitch Ratings’ opinion has entered into bankruptcy
filings, administration, receivership, liquidation, or other formal winding-up procedures or
which has otherwise ceased business.
Default ratings are not assigned prospectively to entities or their obligations; within this
context, nonpayment on an instrument that contains a deferral feature or grace period will
generally not be considered a default until after the expiration of the deferral or grace
period, unless a default is otherwise driven by bankruptcy or other similar circumstance or
by a distressed debt exchange.
Imminent default typically refers to the occasion where a payment default has been
intimated by the issuer and is all but inevitable. This may, for example, be where an issuer
has missed a scheduled payment but (as is typical) has a grace period during which it may
cure the payment default. Another alternative would be where an issuer has formally
announced a distressed debt exchange, but the date of the exchange still lies several days
or weeks in the immediate future.
In all cases, the assignment of a default rating reflects the agency’s opinion as to the
most appropriate rating category consistent with the rest of its universe of ratings and may
differ from the definition of default under the terms of an issuer’s financial obligations or
local commercial practice.
The default rates of different rating agencies differ because of, for instance:
• Different rating universes.

• Different definition of default.
• Moody’s has a no rating called default.
• Grace period could be seen from different ratings provided.
In order to assess the creditworthiness of a bank or an insurance that is not on

based of the creditworthiness of issued bonds of the respective company, Moody is
introducing the following ratings described as follows [see Investor Service Rating
Symbols and Definitions]:
Insurance financial strength ratings are opinions of the ability of insurance
companies to pay punctually senior policyholder claims and obligations and also
reflect the expected financial loss suffered in the event of default. Specific
obligations are considered unrated unless they are individually rated because the
standing of a particular insurance obligation would depend on the assessment of its
relative standing under those laws governing both the obligation and the insurance
company.
Bank deposit ratings are opinions of a bank’s ability to repay punctually its
foreign and/or domestic currency deposit obligations and also reflect the expected
financial loss of the default. Bank deposit ratings do not apply to deposits that are
subject to a public or private insurance scheme; rather, the rating apply to the most
junior class of uninsured deposits, but they may in some cases incorporate the
possibility that official support might in certain cases extend to the most junior class
of uninsured as well as preferred and insurance deposits. Foreign currency deposits
are subject to Moody’s country ceilings for foreign currency deposits. This may
result in the assignment of a different (and typically lower) rating for the foreign
currency deposit relative to the bank’s rating domestic currency deposits.
S&P introduces also ratings that are not based on bonds of the considered
company, for instance, the same as the Insurance Financial Strength Ratings
Bank introduced by S&P under the name claiming paying ability.
Lorenz curve is used for assessing default risks. They are published by S&P. We
are describing the concept in the following.
We will first explain the axis in Chart 5.3. The horizontal axes are the rating
scales ordered from the worst to best scale. The vertical axes show percentage that
defaulted.
Ideally, the rating agency should have been able to predict the bond that
defaulted in the aftermath, that is represented by the curve labeled as ideal curve.
To measure relative rating performance of the rating agency, we utilize the
Lorenz curve as a graphical representation of the proportionality of a distribution
that defaulted. As an example, if “CCC”/“C” rated entities made up 10% of the total
Sample Lorenz Curve A B

(cumulative proportion of defaults, %)
aggregate default rate Lorenz Curve Ideal Curve Random Curve
100
90
A
80
70 B
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
Source: S&P Global Fixed Income Research (cumulative proportion of rated universe, %)
Chart 5.3 Lorenz curve (Source: S&P Global Fixed Income Research)
population of issuers at the start of the time frame examined (horizontal axis) and
50% of the defaulters (vertical axis), then the coordinate (10, 50) would be the first
point on the curve.
If S&P Global Ratings’ corporate ratings only randomly approximated the
default risk, the Lorenz curve would fall along the diagonal.
We consider areas A and B in charts. A is bounded by the Lorenz curve and the
ideal curve, whereas B is bounded by the random curve and the Lorenz curve.
The Gini coefficient is defined by
A
:
AþB
The Gini coefficient captures the extent to which actual rating accuracy diverges
from the random scenario and aspires to the ideal scenario. If corporate ratings were
perfectly rank-ordered so that all defaults occurred only among the lowest-rated
entities, the curve would capture all of the area above the diagonal on the graph (the
ideal curve) and its Gini coefficient would be one.
If the Lorenz curve would fall along the diagonal. Its Gini coefficient would thus
be zero.
We proceed with another aspect of credit analysis. The annual default study uses
annual cohorts. The figures in the transition matrix reflect the changes of the rating
in a particular cohort. For instance, we can see how many companies have changed
the rating. These are the off-diagonal elements. The diagonal of the transition
matrix represents the stabilities of the ratings.
For example, we can determine that a cohort starts in the beginning of 1980 with
1175 companies. At the end of the year, we could observe that four of these
companies defaulted, meaning 0.3% of this cohort defaulted. The main character-
istic of the cohort is that there is no change in the set of companies constituting the
cohort during its duration. The process is repeated for the following year. In 1981,
we start with 1236 companies; two of these companies defaulted. However, many
of these companies are the same companies that were rated last year. For instance,
Ford’s first rating in the database is in 1976, and it continues to be rated today. So
Ford, not having defaulted nor withdrawn in either of these years, would be in both
cohorts. There will be some changes in composition from defaults, withdrawals,
and newly rated companies, so the numbers will change for each cohort.
5.3 Composite Rating
As depicted in Fig. 5.4, different rating providers can assess different ratings of a
specific bond X. Therefore, there is a need for assessing an “overall” rating for bond
X and as a consequence to decide whether a bond is an investment rating. We
proceed with the following definition:
5.3 Composite Rating 143
Rating Provider 1
Bond X Rating Provider 2 Methodology
Rating Provider 3
Fig. 5.4 Different rating providers
Table 5.6 Different Standard & Poor’s A2

composite ratings for
Moody‘s A
a bond
Fitch BBB+
Definition 5.11 The composite rating is a rating that reflects the rating of more
than one rating provider and is thus a synthetic rating.
Composite ratings are needed for:
• The investment guidelines of a portfolio request a minimum rating for a bonds

accepted in a portfolio.
• Index provider produces so-called credit indices. They only accepts bond out of
a certain range of rating or of a specific rating.
The construction of a composite rating is based on the choice of a number of

agencies and a method for assessing a composite rating (see Fig. 5.4). As exposed in
Table 5.6, we assume the following ratings provided by the three big rating
providers.
There are three methodologies for assessing a composite rating of a bond:
An average method reflects all ratings. The scales have to be transferred to a
numerical value. The use of equal weighting might lead to questions. The data in
Table 5.6 leads to A.
Using the worst rating leads to a composite rating that is potentially too
pessimistic. This method shows that not all ratings are reflected. The data in
Table 5.6 will be BBB+.
Using the median rating leads to a composite that does not reflects out the layer.
The data in Table 5.6 leads to A.
Figure 5.5 shows the decision tree of a possibility for the assignment of a rating
to bond X. Often, an issue has no ratings and then the question is what rating can be
used instead. In Fig. 5.5, the rating of the company or the guarantor is applied to the
bonds. A so-called implied rating is then used. If there is no such implied rating, a
local rating provider is used.
We proceed with an example.
Fig. 5.5 Assigning a rating

Yes Bond X
to bond X
No
Yes Grantor
No
Yes Issuer rating
No
Example 5.3 We consider two bonds of the Kantonalbank Schwyz. According to the
SBI rule book, the composite rating is the minimum of the grantor and issue. Since
December 1, 2014, Kantonalbank Schwyz is rated lower than Kanton Schwyz. Most
bonds of the Kantonalbank Schwyz are not rated and the implied rating is the rating of
Kanton Schwyz; however, KBSCHW 1.5% 2017 is rated and the rating is lower than
the rating of the Kanton Schwyz. Since March 19, 2016, Kanton Schwyz is no longer
rated; thus, there are no longer implied rating of a bond from the Kantonalbank Schwyz.
5.4 Optionality
As discussed in Sect. 5.3, the market price, coupon, and time to maturity are
essential for the description of a bond. Here, we discuss an instrument that has no
unique time to maturity. We proceed with the following definition:
Definition 5.12 A callable bond is a bond that can be redeemed by the issuer prior
to its time to maturity.
Remark 5.5 For a high-yield bond, a premium is usually paid to the investor when
the bond is called, while non-high-yield bonds mostly in the banking and insurance
sector have call features with call price par. Yield maturity can diminish because
market rate or spread can tighten. Historically, market interest rate has been higher
than in the last years. With low market interest rates, however, the movement of the
spread has become more important for call feature of a bond.
Remark 5.6 There are bonds that have many call dates (a “call schedule”) that can
be called either over a time span or a specific time. In the following, we assume only
one call date.
If the yield to maturity rates drop, the bond’s issuer will save money by replacing
the callable bond and issuing a new bond at lower coupon rates. A decline of
interest rates can be caused by the market rate or a tightening of the credit spread.
5.4 Optionality 145
Fig. 5.6 Call and put feature
P
Callable Bond
r
Straight Bond
i
Putable Bond
c
e
Yield
In these circumstances, the investor that holds the bond will see his interest
payments stop and obtain the face early. If the investor then reinvests this principal
in a bond again, he may be forced to accept a lower coupon rate that is in line with
the prevailing lower yield to maturity.
A callable bond is worth less (see Fig. 5.6) to the investor. If the yield to maturity
falls, a callable bond has not the same behavior as a non-callable bond. The price of
the callable bond does not climb but the rate of the price increase diminishes and
has a cap. The price-yield relationship is negatively convex and concave for low
yields to maturity (Fig. 5.6), or in short, the callable bond has negative convexity.
The company issuing the callable bond has the power to redeem it and deprive the
investor of the additional interest payments he would be entitled to if the bond was
held to maturity. From the company’s perspective, having the ability to call the
bond adds value because the company is given the flexibility to adjust its financing
costs downward if yields to maturity decline.
In the following example, we illustrate the use of a callable bond.
Example 5.4 Company ABC borrows $10 million in the bond market. We assume
a coupon of 8% which has a time to maturity of 7 years and an issuing price
100, i.e., the yield to maturity is YTM ¼ 0.08. ABC has the option to call the bond
any time after year 3 at a premium of 102 (see Fig. 5.7). Let us assume that, in year
4, the yield of maturity falls to 6% and ABC exercises its right and it borrows
money at YTM ¼ 0.06 and pays back the bond with a coupon of 8% (see Fig. 5.7).
The company has to pay
$10; 200; 000∗ 6% ¼ $612; 000
instead of
$10; 000; 000∗ 8% ¼ $800; 000:

Call protection
t0 = 0 t1 t2 t3 t4
t7 = 7
Fig. 5.7 Callable bond
Definition 5.13 The yield to call rcall is the yield to maturity of a bond if you were
to buy and hold the security until the call date, but this yield is valid only if the
security is called prior to maturity.
The difference between the calculation of yield to call and the yield of maturity
is only the time to maturity.
Example 5.5 (Yield to Call) We consider a bond with a face value $1000 par
value with a coupon of 5% that matures in 3 years and a market price of $1050.
Suppose this bond is callable in 2 years at 100% of par. Then we have
rYTM ¼ 3:22%
and
rcall ¼ 2:40%:
Thus, it is probable that the bond is called after 2 years.
Definition 5.14 (Put Bond) A put bond is a bond that allows the holder to force the
issuer to repurchase the security at specified dates before maturity. The repurchase
price is set at the time of issue and is usually par value.
As illustrated in Fig. 5.6 with declining bond prices, the price of a bond with a
put option is higher than a bond without a put option because it is a right of the
investor.
In the literature (see, e.g., [3]), there are models that price the call of a bond.
Unlike traditional model for pricing an equity option, a model of callable bonds has
to reflect the call price in the future. It has to bridge the price of the bond from
issuance to maturity and to assess the price of the call option. The starting point of
this development was the Ho-Lee model (see [4]). It is a binomial model that is
References 147
path-independent and allows for negative interest rates. The volatility of the yield
curve is the only parameter in the model and no mean reversion is reflected.
References
1. Douglas LG (1993) Fixed income masterpieces. Business One Irwin, Homewood, IL
2. Darrell D, Singleton KJ (2007) Credit risk – pricing, measurement and management. Princeton
University Press, Princeton
3. Hans-Jürg B, J€org W (1996) Pricing callable bonds by means of Green’s function. Math Financ
6(1):53–88
4. Ho T, Lee Sang B (1986) Term structure movements and pricing interest rate contingent claims.
J Financ 41:1101–1029
Different Fixed Income Instruments
6
6.1 Segmentation of the Yield Curve
We use here the notions of risk and riskless in two ways. In Chap. 5, we described a
riskless bond, which means that the bond has no or almost no credit risk and the
investor is only exposed to market risk. In other words, the investors get his money
back at the time to maturity although the time to maturity can be 10 or more years.
The notion riskless interest rate is used extensively in the modern portfolio theory
(MPT) (see, e.g., [1]). The notion riskless interest rate means that capital is
preserved for a short time horizon, for instance, 3 months, 6 months, or 1 year.
The equity world capital can change quite quickly also for short time horizons.
Thus, short-term fixed income instruments are less aggressive and as a consequence
bear less risk than equities. However, there is reinvestment risk for the fixed income
investor as he is exposed to the fluctuation of short-term interest rates.
In Chap. 5, we gave an attempt to classify according to a credit quality, and in
this chapter, we classified according the time to maturity. Money market and
capital markets are distinguished. A money market instrument matures in most
cases up to 1 year at maximum after its issuance. It is said that instruments in the
money market are riskless because they use a riskless interest rate. A prominent
example is treasury bills in the US fixed income market, and in the European fixed
income market money market, instruments are often tied to LIBOR (London
Interbank Offer Rate).
The capital market consists of notes and bonds. A note has a lifetime between
1 and 10 years and bond has a lifetime of more than 10 years. Medium-term notes
are bonds that mature between 4 and 5 years. A convertible bond is in most cases a
note (see Chap. 8).
Needless to say, the terms introduced above are referring to the time between the
issuing date and the maturity date of the bond. The time to maturity from the present
is diminishing, and a straight bond in the last period is technically the same as a
money market instrument.

150 6 Different Fixed Income Instruments
6.2 Floating Rate Note
Opposite to a straight bond (Definition 3.1), the debt instrument introduced in the
following definition has a coupon payment that is periodically adjusted.
Definition 6.1 A floating rate note (FRN) or (for short) a floater is a coupon-
bearing bond whose coupons are floating with an interest rate from the money
market.
FRN bridges the money market with the bond market. The popularity of FRN
arises from the reluctances of many investors to accept a long-maturity fixed bond
particularly in periods where market participants fear rising interest rate. In 1969,
there was a decline in the European market, and the yield curve was inverted. Bonds
were sold and funds were invested short term. FRNs are fixed instruments that have
a similar time to maturity as bonds but are tied to a variable interest rate. The US
treasury bill rate, the LIBOR, the fed funds rate, or the prime rate is usually used for
indexing a FRN. Floaters are mainly issued by financial institutions and
governments. The first prospect that contained the word LIBOR was issued by
the Italian Electricity ENEL in May 1970. It had a time to maturity of 7 years and
was reset every 6 months with 75 basis points over 6 months LIBOR [2].
Referring to Fig. 6.1, we consider a following bullet corporate FRN which
matures at the end of period T and pays a coupon which resets periodically every
3 months. The times of the coupon payments are in time unit year.
j
tj ¼ , j ¼ 0, . . . :, N ¼ 4T:
4
The floating rates are reset 3 months in advance. We derive a pricing formula.
The reset margin (RM) is the difference between the interest and the index on
which the FRN interest rate is based. Assuming that we know the cash flows at It0 ,
It1 ,. . ., ItN with zero rates st0 , st1 ,. . .., stN and the credit spread cs for k ¼ 0,. . .,N1,
we have with the face value F and a market interest r appropriate for the specific
FRN for the invoice price
Cash flow
t0 t1 tj tN
time
Reset date Cash Flow It 0 Projected Cash Flow It j me to maturity
Fig. 6.1 The variable leg of FRN

6.2 Floating Rate Note 151
* +
1 X
N
Itj þ RM F
IPðtÞ ¼ t þ , t ∈ ½tk ; tkþ1 :
ð1 þ rÞtkþ1 t j¼kþ1
t
1 þ stj þ cs j ð1 þ stN þ csÞ N
The projected cash flows can be calculated from the forward curve starting from
the first resettlement date in the future. We assume that a spot curve is given and the
discrete forward interest rate with
sj ¼ Ij
is then

1 þ stj 1 þ tj f tjþ1 ¼ 1 þ stjþ1
which yields
1 þ stjþ1
tj f tjþ1 ¼ 1:
1 þ stj
1 XN
tj f tjþ1 þ RM F þ RM
IPðtÞ ¼ tkþ1 t j þ : ð6:2:1Þ
ð1 þ r Þ j¼kþ1 1 þ stj þ cs ð1 þ stN þ csÞN
The discount margin [DM(t)] is the average expected return earned in addition
to the underlying index. It is defined by
Nk
1 þ stj þ cs ¼ ð1 þ It0 þ DMðtÞÞ ð1 þ t1 f t2 þ DMðtÞÞ

1 þ tj f tjþ1 þ DMðtÞ . . . ::ð1 þ tN1 f tN þ DMðtÞÞ,
which gives
* +
1 X
N
tj f tjþ1 þ RM F þ RM
IPðtÞ ¼ j þ N :
ð1 þ rÞtkþ1 t j¼kþ1 1 þ tj f tjþ1 þ DMðtÞ 1 þ tN 1 f tN þ DMðtÞ
We have
X
N
tj f tjþ1 þ RM ðDMðtÞ DMðtÞÞ F þ RM ðDMðtÞ DMðtÞÞ
IPðtk Þ ¼ j þ N
j¼kþ1 1 þ tj f tjþ1 þ DMðtÞ 1 þ tN1 f tN þ DMðtÞ
X
N
tj f tjþ1 þ DMðtÞ ðDMðtÞ RMÞ F þ DMðtÞ ðDMðtÞ RMÞ
¼ j þ
j¼kþ1 1 þ tj f tjþ1 þ DMðtÞ ð1 þ tN1 f tN þ DMðtÞÞN
and see that

IP(tk) ¼ 1 + present value of an annuity that pays RMDM(t).
In terms of RM and DM(t), we can classify as follows: for RM > DM(t), we have
IP > 1; for RM ¼ DM(t), we have IP ¼ 1; and for RM < DM(t), we have IP < 1.
DM is measured in the secondary market and can be different between resettlement
dates. At resettlement day, we have

DM tj ¼ RM, j ¼ 1, . . . :, N,
and from (1) follows that the FRN is at par. DM(t) allows to measure the
sensitivities of the discount factors. Lemma 5.1 shows that under the assumption
of the flat yield concept, the sensitivities for interest rates and credit spreads are the
same and equal to the modified duration. For a FRN, the modified duration and the
spread duration are substantially different. The modified duration of the FRN is
smaller than the time between resettlement dates, whereas the spread duration has
to be characterized by the creditworthiness of the issuer. A straight bond issued by
the company with the same time to maturity has to be considered.
6.3 Interest Rate Swap
After having discussed straights bonds and FRN, we proceed with an instrument
that is a combination of a straight bond and a FRN. A company will typically use
interest rate swap to limit or manage exposure to fluctuations in interest rates or to
obtain a marginally lower interest rate that it would have been able to get without
the swap. A swap is an exchange of liabilities between two parties for the mutual
advantages ([2], page 77). The first exchange of liability took place in 1981 between
the World Bank and IBM. The World Bank wanted to swap US dollar in
Deutschemark and Swiss franc because interest rates in European were lower
than in the USA, and IBM in turn wanted to swap Deutschmark and Swiss franc
into US dollar because IBM wanted to avoid the depreciation of Deutschmark and
Swiss franc. The swap provided a vehicle that met the need of both counterparties.
A change of liability involves currency or interest rate or both. In the following we
describe an interest rate swap.
Definition 6.2 An agreement between two counterparties where one stream of

future interest payment is exchanged for another based on a specified principal
amount is called an interest rate swap (IRS). Interest rate swaps exchange in most
cases a fixed payment for a floating payment that is linked to a variable interest rate.
Definition 6.3 The swap rate denoted by SW refers to the fixed portion of a swap
and is based on a specific market. It is the rate at which the swap will occur for one
of the parties entering into the agreement.
Remark 6.1 A swap is an agreement between two parties and is thus a differential
business.
6.3 Interest Rate Swap 153
Variable
today
Fix
Fig. 6.2 Receiver swap (refers to fix leg)
Fix
today
Variable
Fig. 6.3 Payer swap (refers to fix leg)
Remark 6.2 IRSs are traded on a spread over the government bond market and are
highly liquid financial derivative.
A swap has a fix leg and a variable leg. A party receives fixed cash flows and
pays variable rates (receiver swap), and the other party receives variable cash flow
and pays fixed cash flows (payer swap) (see Figs. 6.2 and 6.3). In the market, they
have usually the following characteristics:
• The fixed cash flows are fixed till maturity of the swap.
The variable cash flows are fixed at each resettlement day according to actual
market condition.
• Times to maturities of a swap are 2, 3, 4, 5, 7, and 10 years.
As can be seen from Fig. 6.4, we have a par bond for the bond leg and the spot rate
expressed in the underlying period of the resettlement of the variable leg. Thus, we
consider
X
N
0 SWtN 1
1¼ tk þ :
k ¼ 0 ð1 þ 0 stk Þ ð1 þ stN ÞN
1
dk ¼ tk , k ¼ 0, 1, 2, . . . :
ð1 þ 0 stk Þ
Fig. 6.4 Cash flow of an IRS Swap Rate
Swap Seller Swap Buyer

LIBOR+cs
The swap rate 0 SWtN is then
1 dt N
0 SWtN ¼ : ð6:3:1Þ
P
N
dk
k¼1
With swap the risk of a fixed Income Portfolio can be regulated. The market
value MV(t) of the IRS is
1 X
N
j SWtN 1
MVðtÞ ¼ 1 tj þ :t ∈ ½tk ; tkþ1 :
ð1 þ rÞtkþ1 t j ¼ kþ1 1 þ 0 stj ð1 þ stN ÞN
Definition 6.4 The rates of the fixed portion of a swap as determined by its
particular market versus different maturities are the entries of the swap curve.
Remark 6.3 The yield curve of a particular bond market is the equivalent of the
name swap curve for a particular swap market.
Definition 6.5 The swap spread is the difference between the negotiated and fixed
rate of a swap. The spread is determined by characteristics of market supply and
creditor worthiness.
Definition 6.6 An overnight interest rate swap (OIS) exchanges an overnight rate
for a fixed interest rate. An overnight index swap uses an overnight rate index, such
as the federal funds rate as the underlying rate for its floating leg.
The fixed leg has multiple times to maturities; however, the overnight interests
are a good indicator for the interbank credit markets and less risky than other
traditional interest rate spreads. The overnight interests give rise to an overnight
yield curve. The 1 year entry, for instance, is the average of the last overage night
rate of the last year. The overnight interest rate curve is a good approximation of the
riskless rate.
Example 6.1 (Swap with 1 Year to Maturity) We consider an interest swap

with 1 year to beginning at the 01.02.20xx maturity, and the floating leg is settled
6.3 Interest Rate Swap 155
Fig. 6.5 Receiver swap Fix
today
0 0.5 1.0
Year
5.5%
Variable
6.5%
Fig. 6.6 Payer swap 6.5%

Variable
5.5%
0 0.5 1.0 Year
Fix
twice a year, i.e., we have t1 ¼ 0.5, t2 ¼ 1.0 (see Figs. 6.5 and 6.6), and we assume
0 st1 ¼ 6:5%, 0 st2 ¼ 5:5% expressed annually, and for the discount factor, we have
0:5
1
d1 ¼ ¼ 0:9690,
1 þ st1
1
d2 ¼ ¼ 0:9478:
1 þ st2
Compounding annually yields by (1)

2
ð 1 d2 Þ
0 SWl ¼ 1þ 1 ¼ 5:9357:
ð d1 þ d2 Þ
Example 6.2 Monitoring the Interest Exposure of a Fixed Portfolio By

denoting the portfolio ending value PE, the portfolio beginning value PB, the
IRS with beginning value SEp, and ending value SBp, the return rp is then
PE þ SEp PB SBp
rP ¼
PB þ SBP
and we denote the duration of IRS by dP. The benchmark IRS portfolio consists of
the same bond portfolio and a portfolio of three IRS with time to maturity 5, 7 and
10 years and durations d1, d2, and d3 such the overall Macaulay duration of the IRS
portfolio is 4 years. The underlying portfolio is unchanged, and by denoting the
beginning value by SEB and ending value by SBB, we have
PE þ SEB PB SBB
rB ¼ :
PB þ SBB
The duration of the IRS portfolio is
dB ¼ w1 d1 þ w2 d2 þ w3 d3 :
As the duration of a portfolio diminished through time, the duration of 4 years

can be adjusted by changing the weights. An active portfolio manager pursuing an
active interest strategy buys an IRS portfolio and compares his or her return versus
the benchmark return. There are the following cases:
(a) dp < dB: If interest rates are declining or increasing, respectively, the portfolio
manager will underperform or outperform, respectively. And if interest rates
are increasing or declining, respectively, the portfolio manager will outper-
form or underperform, respectively.
(b) dB < dP: If interest rates are declining or increasing, respectively, the portfolio
manager will outperform or underperform, respectively. And if interest rates
are increasing or declining, respectively, the portfolio manager will
underperform or outperform, respectively.
Remark 6.4 Geometrically linking requests the division by the market value. As a
consequence, isolating interest rate swaps are problematic for geometrically linking
as they have no market value at issuance and have a market value that can be
positive or negative. Usually, they are assessed in context of a bond portfolio. We
illustrated this in Example 6.2.
Example 6.3 Institutions like pension funds have assets and liabilities. By using
IRS, the duration of the two parts of the balanced sheet can be matched.
Example 6.4 Reshuffling the portfolio is costly. If the portfolio manager is

forecasting rising interest rates for the whole or parts of the yield curve, he can
buy an appropriate IR.
6.4 Asset Swap 157
6.4 Asset Swap
In a plain vanilla swap, a fixed rate is swapped for a floating LIBOR. As depicted in
Figs. 6.7 and 6.8 in an asset swap, a fixed investment such as a bond with
guaranteed coupon payments is being swapped for a floating investment such as
an index.
Definition 6.7 The underlying of an asset swap is a coupon paying corporate bond,
and the cash flows are analogous to the interest rate swap. Fixed and floating
investments are being exchanged. More specifically, the buyer will pay the coupons
distributed by the bond to the seller of the swap. And the seller on the other side will
pay a floating interest rate, e.g., LIBOR, plus a spread in return for this. This spread
is called the asset swap spread (ASW).
The pricing formula for a credit spread cs is
X
N
C FþC X
N
tj f tjþ1 þ cs F þ cs
j
þ N ¼ j þ N :
j¼1 ð1 þ r Þ 1 þ tN 1 f tN j¼1 1 þ tj f tjþ1 1 þ tN1 f tN
Example 6.5 Figure 6.9 shows an analysis of the asset swap spread of the floating
leg versus the duration of the Swiss insurance bonds contained in the SBI (Swiss
Bond Index) Universe in 2013. It uses the duration because the duration combines
different characteristics of the bonds (see Sect. 3.1). If we use the time to maturity
to plot against, the spread would be different for different coupons and same yield
to maturities. Price would not be reflected in such an analysis. The companies have
Fig. 6.7 Initial set up Bond

Asset Swap Asset Swap
Seller Buyer
Par
LIBOR+ASW
Asset Swap Asset Swap Bond
Seller Buyer
Coupons
Fig. 6.8 On default LIBOR + ASW

Asset Swap Asset Swap
Seller Buyer
Coupons
80
70
60
50
ASW spread (bp)
Zurich Ins, senior, High A
40 Swiss Re senior, low AA

Swiss Life, senior, High BBB
Helvtia, senior, High BBB/Low A
30
Balos senior, High BBB
20
10
0
0 2 4 6 8 10 12
Duration (y)
Fig. 6.9 ASW Swiss insurances
different ratings, and we see that the spreads reflect the overall rate scales. Different
spreads within the same do reflect the different characteristics of the bond.
References
1. Wolfgang M (2015) Portfolio analytics, 2nd edn. Springer International publisher, Cham
2. Chris O’M (2015) Bonds without borders. John Wilson & Sons Ltd, Chichester
Fixed-Income Benchmarks
7
7.1 Definition and Fundamental Properties
In this section, we investigate portfolios that are constructed by stringent rules or

which, differently expressed, are not the result of a subjective investment process.
The construction of a benchmark is a transparent and object process. We start with
the following definition:
Definition 7.1 A reference portfolio is called a benchmark portfolio or simply a

benchmark.
Definition 7.2 If an investor opts for short-term interest rates (e.g., 3mLibor) and
not for a portfolio, the investor uses an absolute benchmark.
Remark 7.1 The term index is the same as benchmark.

A reference portfolio is used for measuring the relative return of a portfolio, and
an absolute benchmark is used for measuring the absolute return of the portfolio [1].
The assignment of a benchmark to a portfolio is paramount. The return of a
portfolio is measured against the return of the benchmark. The identification of a
benchmark should be a long-term decision as with change of the benchmark the
portfolio loses his or her tracking record. As a consequence, a change of the
benchmark is a bad sign for the portfolio manager, and the confidence in the
portfolio manager is hampered. In the finance industry, two kinds of benchmarks
are distinguished:
1. Benchmark portfolios that are well known are called industry-standard

benchmarks. They are provided by MSCI and FTSE for the Equity Universe
and provided by J.P. Morgan, Citigroup, Barclays, and Merrill Lynch for the
fixed-income universe. A typical is the J.P. Morgan Global or the MSCI World.
Industry-standard benchmarks allow for peer analysis and are transparent.
Benchmarks are great marketing tools and are not altruistic.

160 7 Fixed-Income Benchmarks
2. Benchmarks that are tailored for a specific investment strategy or a particular

client request are called tailor-made benchmarks. An investor that is allowed to
invest globally except in certain countries or industries will often choose a global
benchmark without these countries and industries. That is a typical example of a
tailor-made benchmark. We discuss tailor-made benchmark in Sect. 8.3.
Benchmarks are paper portfolios, i.e., they do not in general consider

transactions costs and taxes in particular withholding taxes. The portfolio manager
has always a disadvantage against the benchmark, and the passive portfolio man-
ager stays always behind the benchmark. The choice of the benchmark is subject to
discussion. Benchmarks in generally pursue the following purposes:
• A comparator for different markets.

• To act as an indicator of market performance and development.
• The basis on which market option and futures may be derived.
• Benchmarks are marketing vehicles and are thus altruistic. However, in general,
not all information of the benchmark is free of charge. Often the return of
benchmark is publicly available, but the constituents of are benchmark portfolio
are proprietary or depend on the business relationship between the user and the
provider of the benchmark.
7.2 Constructing a Fixed-Income Benchmark
Initially the big investment banks have published benchmark that invests in
governments bonds. The benchmark industry has expanded tremendously over
the last 10 years. Many segments of the bond market are measured or monitored.
Bonds that have the same or similar properties are considered in a portfolio:
• (Selection) Only bonds that have a minimal seize are included in the benchmark.
It is argued that bonds with smaller issue size are illiquid.
• (Inclusion) The inclusion of a newly issued bond can be included immediately or
at the end of the month.
• (Reinvestment of the cash flows) In the industry, there are mainly two kinds for
reinvested of the coupon:
– The coupon is reinvested in all bonds simultaneously overnight. The portfolio
is always invested in the bonds of the benchmark portfolio.
– The coupons are collected during a month and reinvested at the end of month.
Some index providers apply a short interest rate to the portfolio of the coupon
during the month. We have a bias to short-term rates, but the portfolio
manager is appropriately mimicked.
7.2 Constructing a Fixed-Income Benchmark 161
• (Exit from the benchmarks) The bonds that have a time to maturity less than
1 year are excluded from the benchmark portfolio because they are seen as
money market instruments. The experts are discussing whether this condition
makes sense because the portfolio managers do not sell the bonds before they
mature.
• (Application of a transparent rule book) The adjustment and revision of the
benchmark portfolio is mechanical and according to a rule book and mostly on a
monthly basis.
Most fixed-income benchmarks are capital weighted. In the fixed-income area,

there are essentially two types of benchmarks:
• A total return benchmark (abbreviation TR) is to measure the total return of the
benchmark portfolio, i.e., the capital movement and the accrued interest
contributes to the return.
• A price index measure (abbreviation PR) the price movement of constituents and
coupons are not reflected. They measure only the market movement.
TR and PR are ex post return measure and are measured by TWR (see, for
instance, [1]). The return of a bond and a portfolio is not discussed here. As
discussed in Sect. 3.5, the yield of a portfolio, however, is an ex ante measure for
the portfolio. The index providers are approximating the internal rate of return by a
weighted average of the yield of maturity of it constitutes.
The number of the security in specific benchmark can vary. A big benchmark
portfolio is sometimes difficult to monitor, and analyzing the resulting return can be
a substantial task.
The return of a portfolio can also be referenced to a specific bond. We proceed
with the following definition:
Definition 7.3 A benchmark bond is a bond against which the return of bonds with
similar characteristic can be measured and compared.
Remark 7.2 Government bonds are almost always chosen as benchmark bonds.
More specially, a benchmark bond is the latest issue with a given maturity. For a
comparison to be appropriate and useful, the benchmark bond and the bond to be
appropriate should have a comparable liquidity, issue size, and coupon. A bench-
mark bond is often used as an indicator of the return of a specific bond market.
Example 7.1 In Fig. 7.1, we see the yields of the 10 year benchmark bond of the
Japanese (JGB), the US (Treasury), the German (Bund), and the English (Gilts)
bond market.
Fig. 7.1 Benchmarks yield (Source Thomson Reuters)
7.3 Recent Developments in the Benchmark Industry
Traditionally, the fixed-income benchmarks are capital weighted. The weights in

the benchmark reflect the degrees of debt of the issuer of the bonds. The investor
does not necessarily want to be heavily invested with such investments as they have
an over proportionally weight in the benchmark. This can occur on country, sector,
or even on security level. For instance, there was a period when the size of
outstanding bond in the telecommunication sector was not appropriate for the
portfolio manager. Considering the credit worthiness, he would take an additional
risk. Thus, other weighting schemes are considered. The benchmark provider,
however, are offering also capped or constrained benchmark ([2], page 138).
Recently, the number of tailor-made benchmark has increased, and as a conse-
quence, a peer analysis can be problematic when not even possible. We proceed by
two illustrations.
Firstly, there are often legal or institutional constraints on the composition of
portfolios. Under these circumstances, a standard market capitalization-based index
weighting may not correctly reflect the constraints. Often the portfolio manager
may adhere to a tailor-made benchmark that can be reflected by the portfolio
manager. As a general rule in portfolio management, we claim that the portfolio
manager can move to benchmark if he sees no opportunities in the market.
7.4 Fixed Income as Asset Class 163
Secondly, in the fund industry, there is a rule that says a single position is not
more than 10% and the five biggest position of the position should not excess 40%
of the portfolio. Accordingly MSCI provides benchmarks that reflect these
proportions.
While the term smart beta is being used in an increasingly convoluted fashion
across the industry, we here attempt to give a definition as we see it.
Definition 7.4 Smart beta defines a set of investment strategies that emphasize the
use of alternative index construction rules to traditional market capitalization-based
indices. Smart beta emphasizes capturing investment factors or market
inefficiencies in a rule based and transparent way. The increased popularity of
smart beta is linked to a desire for portfolio risk management and diversification
along factor dimensions as well as seeking to enhance risk-adjusted returns above
cap-weighted indices.
Remark 7.3 (Different Portfolio Strategies)

• The optimal portfolio depends on the market movement. Although a forecast
might be kept constant, the return of the forecast can change with the market
movement. The time between consequent optimization is a decision of the
portfolio manager and defines a particular strategy; therefore there is a saying
that ‘Optimality is the enemy of Stability.’
• In [3] it is shown that the proxy of a market portfolio is inefficient. The
realization of the calculating market has a worse return risk ratio than the market
portfolio on the efficient frontier. The minimum variance [4] is invested exten-
sively in the literature. It offers reduced risk and better return. This strategy is
particularly attractive in bearish markets and has been realized by, e.g.,
Unigestion.
• An optimization over segments or markets omits the security selection, and asset
class or segment of the financial obeys better the assumption of the normal
independent distribution than individual securities.
• There are other investment strategies based on a specific rule like pursuing a
specific investment style, investing in equally weighed portfolio, or investing in
equally risk portfolios.
7.4 Fixed Income as Asset Class
Benchmarks are important throughout the finance industry. Thus, we need the
following two notions:
Definition 7.5 (Balanced Portfolio) A portfolio that combines a stock component,

a bond component, and, sometimes, a money market component in a single
portfolio is called a balanced portfolio.
Generally, these hybrid funds stick to a relatively fixed mix of stocks and bonds
that reflects either a moderate (higher equity component) or conservative (higher
fixed-income component) orientation. However, as this mix changes as markets are
moving, benchmark portfolios and potentially the portfolio itself have to be
rebalanced. The time pattern for rebalancing is a subjective decision of the portfolio
manager.
Definition 7.6 (Asset Class) An asset class is a group of securities that exhibit
similar characteristics, behave similarly on the marketplace, and are subject to the
same laws and regulations. The three main asset classes are equities (stocks), fixed
incomes (bonds), and cash equivalents (money market instruments).
Tailor-made portfolios as benchmark portfolios are used widely for balanced
portfolios. The components for the different asset classes are often industry
standards. Contrary to capitalization-weighted fixed-income benchmark,
capitalization-weighted equity income benchmark include only shares that can
be bought publically (floating shares).
The proceeding texts originated from the different benchmark provider and from
information that is publicly available. As can be seen from the following, every
benchmark provider pretends to be the best without comparing with peers in the
industry. A detailed peer analysis is often difficult and laborious. It is left to future
research and is beyond the scope of this book.
7.4.1 Equity Benchmarks
FTSE Russell is a leading global index provider creating and managing a wide
range of indices, data, and analytic solutions to meet client needs across asset
classes, style and strategies. Covering 98% of the investable market, FTSE Russell
indices offer a true picture of global markets, combined with the specialist knowl-
edge gained from developing local benchmarks around the world.
FTSE Russell index expertise and products are used extensively by institutional
and retail investors globally. More than $10 trillion is currently benchmarked to
FTSE Russell indices. For over 30 years, leading asset owners, asset managers, ETF
providers, and investment banks have chosen FTSE Russell indices to benchmark
their investment performance and create investment funds, ETFs, structured
products, and index-based derivatives. FTSE Russell indices also provide clients
with tools for asset allocation, investment strategy analysis, and risk management.
S&P Global umbrella consists of S&P Market Intelligence, S&P Index, and
S&P Ratings. These divisions all operate separately, and there are certain firewalls
between them that prevent information sharing. For example, both S&P Market
Intelligence and S&P Ratings will receive bond information but are not permitted to
pass it on to the other side. So basically the connection is that we all fall under the
same overarching organization but operate independently.
For more than 40 years, MSCI’s research-based indices and analytics have
helped the world’s leading investors build and manage better portfolios. Clients
rely on their offerings for deeper insights into the drivers of performance and risk in
their portfolios, broad asset class coverage, and innovative research. Investors
around the world use their well-respected performance and risk management
analytics to navigate today’s complex markets. MSCI indexing offers a modern,
seamless, and fully integrated approach to measuring the full equity opportunity set,
with no gaps or overlaps. The Modern Index Strategy enables the construction and
monitoring of portfolios in a cohesive and complete manner, avoiding benchmark
misfit and uncompensated risks. At the core is MSCI’s index methodology, which
provides consistent treatment across all markets and ensures best practices in
investability, replicability, and cost efficiency.
STOXX Ltd is an established and leading index specialist with a European
heritage. The launch of the first STOXX® indices in 1998, including the EURO
STOXX 50® index, marked the beginning of a unique success story based on the
company’s neutrality and independence. Since then, STOXX has been at the
forefront of market developments and has continuously expanded its portfolio of
innovative indices. STOXX now operates globally across all asset classes. STOXX
indices are licensed to more than 500 companies globally which include the world’s
largest financial products issuers, capital owners, and asset managers. STOXX
indices are used not only as underlying for financial products, such as ETFs, futures,
and options, and structured products but also for risk and performance
measurement.
In addition, STOXX Ltd is the marketing agent for DAX® and SMI® indices. For
you this means one sales team for three index brands and one single point of
contact.
7.4.2 Fixed-Income Indices
Citi fixed-income indices deliver market-tested and comprehensive benchmarks,

trusted and widely followed by the global investment community. With over
30 years of experience in benchmarking, Citi’s fixed-income indices offer a com-
prehensive family of indices with a broad array of currencies, regions, and asset
classes.
Based on objective rules, Citi’s fixed-income indices strike a balance between
comprehensiveness and replicability, making them appropriate for fund managers,
ETF issuers, and sponsors. A unified methodology across markets enables investors
to use these indices as building blocks for customized benchmarks based on specific
needs.
Citi fixed-income indices’ flagship index, the World Government Bond Index
(WGBI), measures the performance of fixed-rate local currency investment grade
sovereign bonds. This widely adopted benchmark comprises sovereign debt from
20+ countries denominated in 15+ currencies. The index was created in 1986 and
offers more than 30 years of history.
The J.P. Morgan index product suite includes extensive coverage of developed
markets spanning global treasury (GBI and EMU family) and the USD and euro
credit markets (JULI and MAGGIE series) in the investment grade spectrum.
J.P. Morgan’s Global Government Bond Index (GBI) was first launched in 1989
and has since grown to be among the most widely used benchmarks for global
investors in developed government bond market. The GBI Global was designed to
include only the core local treasury markets offering the highest levels of market
depth and liquidity. There are 13 countries in the original composition, which has
remained unchanged since inception.
Our latest flagship, the GBI-AGG Diversified, launched in October 2016,
provides investors with a comprehensive, investable benchmark that spans across
all liquid, local currency government markets in both developed and emerging
market countries. The benchmark applies a unique currency diversification scheme
versus the traditional country or issuer-based diversification providing a more
dynamic weight allocation.
Along with the GBI-AGG series launch, two new variants were also introduced
in October 2016 targeting both developed markets and more advanced EM
economies covering all liquid, local currency government bonds. The two variants
are GBI-DM and GBI-CM along with their diversified variants, respectively.
The EMU Government Bond Index (EMU), launched in 1998, is a primary
indicator of eurozone fixed-income performance and supplements the coverage of
global government bonds. In 2009, the EMU Government Bond Investment Grade
(EMU IG) Index was created which includes only investment grade countries. As
the European markets evolve, the EMU IG will serve to maintain a high quality and
liquid composition of countries within the eurozone.
The EMU index is also a key component of J.P. Morgan’s Aggregate Index
Euro, the MAGGIE, which enables investors to track corporate, government, and
Pfandbriefe investment grade liquid euro-denominated debt.
The J.P. Morgan US Liquid Index (JULI) measures the performance of the
investment grade US dollar-denominated corporate bond market and in conjunction
with other J.P. Morgan credit benchmarks (MAGGIE, CEMBI, Global HY index)
provide comprehensive indexing capabilities across the global corporate bond
markets. The J.P. Morgan Global High Yield Index is designed to mirror the
investable universe of the US dollar high yield corporate debt market.
J.P. Morgan also offers a range of indices covering inflation-linked government
securities. Created in 2004, the JUSTINE index acts as a benchmark for US
Treasury inflation-linked products (TIPS). The ELSI index, also created in 2004,
caters to inflation-linked bonds issued by eurozone governments. Finally, the

GILLI index, introduced in 2012, tracks the performance of the UK government
inflation-linked gilts.
The DM index suite also includes US agency index, total return swap indices
(TRSI), sterling credit indices (GBP Credit), euro/sterling subordinated debt indices
(SUSI), as well as various cash indices that provide an effective cash deposit rate
using interpolated LIBOR. This coverage was enhanced with the launch of the
Global Aggregate Index (GABI) in 2008 representing a new foundation which ties
together established J.P. Morgan indices and serves as a platform for future index
products based on the broader global market. The recently launched J.P. Morgan
CLO Index (CLOIE) and the J.P. Morgan Asset-Backed Securities (ABS) Index are
the newest addition to the DM index suite. As the first US CLO index of its kind, the
CLOIE tracks floating-rate CLO securities in 2004 to present vintages. The ABS is
a comprehensive US ABS benchmark that captures 70% of the size of the US ABS
market (~$680 billion).
Since 1973, the Bloomberg Barclays Indices have been the most widely used
indices for fixed-income investors seeking objective, rules-based, and representa-
tive benchmarks to measure asset class risk and returns. Whether published under
the banner of Kuhn Loeb, Lehman Brothers, or Barclays, these indices have
provided investors with a wealth of market information. On August 24, 2016,
Bloomberg acquired these assets from Barclays. Barclays and Bloomberg have
partnered to co-brand the indices as the Bloomberg Barclays Indices for an initial
term of up to 5 years.
The indices of BofAML (Bank of America Merrill Lynch) exist since 1986.
They are available on Bloomberg in very transparently on a constitute level by the
Bloomberg key IND. The BofAML indices cover over 5000 indices tracking $50
trillion in fixed-income securities. BofA Merrill Lynch Bond Indices are a broad-
based universe currently spanning over 60,000 fixed-income securities
denominated in 41 currencies. Together, they cover the global high-grade, high-
yield, and emerging markets.
7.4.3 Hedged Fixed-Income Indices
Every index is available in unhedged and hedged version. This is done by one
monthly forward contract. As market is forward, the hedge might be over hedged or
under hedged. If a base currency is strengthening against the local currency of the
bond, the portfolio manager that hedge is losing versus unhedged position.
The performance return of the hedged position is easily available, but the
underlying positions are often proprietary.
7.4.4 Commodity Index
A commodity price index is a fixed-weight index or (weighted) average of selected

commodity prices, which may be based on spot or futures prices. It is designed to be
representative of the broad commodity asset class or a specific subset of
commodities, as, for instance, metals. It is an index that tracks a basket of
commodities to measure their performance. These indices are often traded on
exchanges, allowing investors to gain easier access to commodities without having
to enter the futures market.
The first such index was the CRB (“Commodity Research Bureau”) Index,
which began in 1958. Due to its construction, it was not useful as an investment
index. The first practically investable commodity futures index was created by the
Goldman Sachs Commodity Index (GSCI) in 1991. The next was the Dow Jones
AIG Commodity Index (DJ AIG). It differed from the GSCI primarily in the
weights allocated to each commodity. The DJ AIG had mechanisms to periodically
limit the weight of any commodity and to remove commodities whose weights
became too small. After AIG’s financial problems in 2008, the Index rights were
sold to UBS and it is now known as the DJUBS Index. Other commodity indices
include the Reuters/CRB Index (which is the old CRB Index restructured in 2005)
and the Rogers Index.
A tailor-made benchmark consisting of portfolios in different asset classes are
discussed below
Example 7.2 In Fig. 7.2, we have the return of a Credit Suisse composite called
MACS (Multi Asset Class Solutions), the cumulative return of the peers’ portfolios
190.00
175.00
160.00
145.00
130.00
Axis Title
50% Bond & 50% Equity

Barclay Aggregate Bond Index
115.00 S&P500
Reuters Global Convertibles
100.00
85.00
70.00
55.00
Fig. 7.2 Cumulated return

provided by Lipper. Lipper is a global leader provider in independent fund perfor-

mance data. The cumulative return of the benchmark portfolio consisting of:
15% JPM Cash ECU 1M (money market index)

5% DJUBS TR EUR (commodity index)
60% JPM EMU TR 1–10 Y (fixed-income index)
8% MSCI Europe TR—Net Dividends (equity index)
12% MSCI World TR net (equity index)
The portfolio is actively management and the portfolio is rebalanced bi-weekly;

we see that the portfolio manager underperforms his or her benchmark but
outperforms a composite provided by Lipper. The benchmark portfolio is balanced
monthly.
In the following, we investigate the behavior of different equity, bond, and cash
markets and the behavior between these markets. We would like to find out if the
mean and (co-) variances of the historical prices describe market behavior well. If
that would be the case, variance would be sufficient as a measure of risk. Let us
refer to this ideal condition as “normal markets.” The tools of modern portfolio
theory would be open to us and describe what we observe. We could also use these
tools to construct portfolios that satisfy desired properties. As example we use the
US Market and the Swiss Market with time series representing the equity markets,
the bond markets, and the cash markets. Starting points are the historical
covariances and the historical variances. Current statistical procedures like the
Shapiro-Wilk test [5] find that these markets do not display market normality in
its general form. It is clear that we need to have a closer look if we want to
understand the ways in which normality fails and where parts of it might be
salvaged. To do that, we employ a kind of visual analytics approach. More specifi-
cally, we simulate the given markets under the explicit condition that the normality
assumption is valid and enforce it in the simulations. All other parameters remain
identical to the original data. Comparing this idealized data set to the real-life
observations might give us clues where and how normality fails and where it might
still be very useful. The mathematics behind this simulation is in Appendix J or
[1]. As example we choose indices from fixed-income and equity market of
Switzerland and the USA together with the Swiss franc and the US dollar. Figure 7.3
shows scatterplots of the return observations of the markets versus the other
markets. The charts on the diagonal display a histogram of the return that closely
resembles a normal distribution. The off-diagonal charts show more or less strong
linear relationships between the markets that seem to resemble “cotton wads.” This
is expected for normal markets. Figure 7.4 shows the same type of plot, this time
taken from the real-world return observations. Comparing the Figs. 7.3 and 7.4, we
see that:
• Actual price paths of cash markets are very far from the ideal elliptic “cotton
wads” of Fig. 7.3. Modeling cash markets using modern portfolio theory is
probably not the best idea.
Fig. 7.3 Normal distributed
• Bond and equity markets seem quite similar to their simulation counterparts. On
a closer look, the real-world “cotton wads” have more sprinkles on the perimeter.
These are the famous “fat tails.” The “fat tails” seem more or less symmetrically
distributed to the up- and downside. In such cases, we might successfully use
modern portfolio selection if we bear in mind that extreme events to the up- and
downside are likely to happen that we cannot directly account for. Portfolio
selection will not change as long as the unexpected large negative events are
compensated on the far end of the positive side. Variance-based risk measures
will nevertheless underestimate the risk of large losses and gains.
• A closer look shows at the data that shortfall, i.e., are also accompanied by
windfalls, i.e., expected profit.
References 171
Fig. 7.4 Observed data
References
2. Patrick B (2002) Construction & calculating bond indices, 2nd edn. Glamour Drummond
Publishing, Cambridge
3. Robert D, Wolfgang M, Christoph O (2001/2002) Performance of quantitative versus passive
investing: a comparison in global markets. J Perform Meas 6(2):29–41
4. Kleeberg Jochen M (1995) Der Anlageerfolg des Minimum Varianz Portfolios. Schriftreihe
‘Portfoliomanagement’ Uhlenbruch, Bad Soden
5. Samuel S, Martin W (1965, December) An analysis of variance test for normality (complete
samples). Biometrika 52(3/4):591–611
Convertible
8
8.1 Basics Notions
In the following, we consider a subset of corporate bonds and consider an instru-

ment that connects the asset classes fixed income with equity. We proceed with the
following definition:
Definition 8.1 (Convertible Bond) A corporate bond that can be converted into a
predetermined number of the company’s equity at certain times during its life is
called a convertible bond (CB).
In this section, we describe the basic features of a CB. A CB is a type of an
equity-linked bond. There are often issued by companies that are expected to grow
substantially in the near future. Assuming that the investor of the issuer of the CB
has the right to convert in equity before the time to maturity, Fig. 8.1 shows the two
different scenarios of the potential cash flows. The investor receives first the
Coupon C of the CB, and then by converting, he exchanges the Coupon C by the
dividend D of the underlying stock. The time of maturity is the last point in time the
investor can convert in stocks otherwise the CB expires. During the life of the CB,
the investor has the choice between an instrument that has a finite live and an
instrument with an infinite live.
In the following we invest the behavior of the stock and the interest separately
following by examining the embedding option in the CB. However, we proceed
with the following remarks:
Remark 8.1 CBs are not hybrid instruments. Hybrid instruments are unsecured,
subordinated fixed-income instruments whose coupons are uncertain, i.e., the
coupon is dividend like and they can never be exchanged in stocks. CBs, however,
are secured not subordinated fixed-income instruments equipped with the right to
exchange a bond by a number of the stocks of the underlying stock.

174 8 Convertible
Decision making:
Conversion Face (F) +
Coupon (C)
Coupon (C)
price (P) =100
Invoice time
accrued interest
price
time
Coupon (C)
Dividend (D)
today Flat price

time
Fig. 8.1 The basic features of a CB
Remark 8.2 Interest rates and stock price are market data. Although they are
thought as an independent variable of for the CB price, the dependency of these
variables has to be left scrutinized in future research.
8.2 The Stock Behavior
The value of a stock is always positive. As shown in Fig. 8.2, a stock is a line with
slope 1, and a portfolio with two stocks is a line with slope 2. In Fig. 8.2 we see the
payoff (PO) of a stock with price S and a payoff of a portfolio consisting of a
portfolio with two stocks. It is assumed that the investor buys at the price 100 and
shows the price of one or two stocks at the point in time he sells. In addition, in
Fig. 8.2, we see the payoff (PO) of one stock and two stocks in the time span
between buying and selling. The stock and the PO behave linearly.
The CB investor has the right to convert one unit of the CB in a number fixed at
issuance. More specifically we introduce the following two notions:
Definition 8.2 The conversion ratio κ is the number of shares the investor receives
when converting one unit of the CB.
Definition 8.3 The conversion price SC is the implied purchase price of the stock
in the CB’s currency of the convertible by conversion.
8.2 The Stock Behavior 175
400
300
200
one stock
two stock
100 Payoff one stock
Pay off two stock
0
0 100 200
-100
-200
Fig. 8.2 Payoff of a stock
Conversion ratio and conversion price at the issuance are specified in the
prospectus along with other provisions. There are static data, and we proceed by
two notions that are based on market data.
Definition 8.4 The conversion value or equity value or the parity P(S) is the value
one would hold if one unit of the bond is immediately converted into stocks. The
linear functions P(S) is defined by
PðSÞ ¼ κS
is called the parity.

Denoting the face value of the CB by F, the PO of a CB at the time of maturity is
POðTÞ ¼ MaxðF; κ x SðTÞÞ: ð8:2:1Þ
Remark 8.3 Unlike straight bonds, convertible bonds have upside potential.
Remark 8.4 The conversion value moves linearly with the stock price.
Definition 8.5 The conversion premium or the premium to parity rc indicates how
much a convertible bond an investor is willing to pay to own the convertible as
opposed to the underlying share.
Example 8.1 (Model Example) We consider a CB with time to maturity T, Face

Value F ¼ 100 and a conversion ratio κ ¼ 20 means one bond (with a $1000 par
176 8 Convertible
value) can be exchanged for 20 shares of stock. We assume that the stock would be
$40.
1. The Price of a Stock would be S(T) ¼ $50, and the conversion premium rC is
$50 $40 10
rC ¼ ¼ ¼ 0:25, i:e:, in percent 25%: ð8:2:2aÞ
$40 40
2. If rC ¼ 0.25 the conversion value would be
$40 1:25 ¼ $50: ð8:2:2bÞ
The conversion premium and the conversion value at issuance of the CB are the
same.
Example 8.2 We consider the CB issued by Prysmian, a world leader in the

industry of high-technology cables and system for energy and telecommunications.
The coupon is 1.25%. The issue price is 100% of par, redemption price is also 100%
of par, and the size is 300 million. The denomination is EUR 100,000 per bond. The
reference share price is EUR 16.6839, and the initial conversion premium is
33.75%. The initial conversion price is
EUR 16:6839 ð1 þ 33:75%Þ ¼ EUR 22:3146:
8.3 The Bond Behavior
The yield to maturity (YTM) (see Definition 3.12) and the direct yield (DY)
(see Definition 3.14) of a straight bond can also be calculated for CBs. In the
calculation of the YTM, the time of the maturity is critical, and the DY can be seen
as a yield with the time to maturity being infinite. A CB, however, has other critical
times during the life of the CB. At a call date and put date, resp., the issuer and
the investor, resp., can redeem the CB. Many CBs have a call provision between
two call dates, i.e., the CB can be called during a time span, whereas the put
dates are, in most cases, discretionary points on the time axe. With this notion, we
define:
Definition 8.6 By exchanging the time to maturity by the first call date in the yield
to maturity calculation, the corresponding yield is called the yield to call (YC).
8.3 The Bond Behavior 177
Definition 8.7 The minimum of the yield to maturity and the yield to call is called
the yield to worst (YW), that is, we consider
YW ¼ minðYC; YTMÞ:
Definition 8.8 By exchanging the time to maturity by a put date in the yield to
maturity calculation, the corresponding yield is called the yield to put (YP).
Remark 8.5 The yield to worst helps investors to ensure that specific income
requirements will still be met even in the most adverse scenario.
Contrary to a straight bond, a CB is a combination of a bond and an out of money
call option at issuance. A par CB is thus a discount bond and call option on the
underlying stock. We define thus:
Definition 8.9 The investment value or the bond floor (BF) is the present value of
the embedded cash flows in CB. Call options are disregarded, but put options are
reflected as they have an investment value.
Remark 8.6 Usually, the bond floor is only exposed to the interest rate market and
credit markets. This entails also the default risk of a bond.
Example 8.3 (Model Example, Continued) The premium is 25%. That means
that if the investor chooses to convert the shares, he or she will have to pay the price
of the common stock at the time of issuance plus 25%. At issuance the investment
value is 80% (Fig. 8.3). If there is no conversion between O and T, the investment
Investment Value at issuance

180
160
140
120
100
80
60
0 50 100 150 200
Stock Price
Fig. 8.3 The fixed-income character

178 8 Convertible
will increase to 100%. If the price of the stock is beyond 50, then the CB will be in
the money, and the investor will latest convert at time of maturity of the CB. We see
that the payoff of the CB will change through time.
(8.2.1) is the same as
POðTÞ ¼ F þ Maxð0; κ x SðTÞ FÞ: ð8:3:1aÞ
This equation is the replication of a CB by a bond and a long call option. By

using the call parity, (1a) is the same as
POðTÞ ¼ κ SðTÞ þ MaxðF κ x SðTÞ; 0Þ: ð8:3:1bÞ
This equation is the replication of a CB by holding κ shares and a European put

option to sell these returns for the face value F.
We could do a performance attribution. The price of a bond can be decomposed
by in a part that relates to the fixed-income market and a part that relates to the
option of the bond. The following shows the input, description of the convertible,
and the produced number that CB can be described. We distinguish between market
data and static data. Market data are the fixed-income rate market where the bond
was issued and the underlying stock price.
The equation for the price of the bond floor BF of the CB which pays a coupon
annually or semiannually, respectively, is
X
N
C F
BFðrÞ ¼ þ ,
j¼1
j
ð1 þ r Þ ð1 þ r ÞN
X
2N C
F
BFðrÞ ¼
2
þ 2N , resp:
r j
j¼1 1þ2 1 þ 2r
As the BF is in most cases not traded, the BF has to be computed from static data,
the time to maturity tN, and the discount rate r. As discount rate, a riskless rate with
a credit spread for the investor is used.
8.4 The Embedded Call Option
An option of a stock is the right to buy a stock at a price (strike price) fixed at
issuance. The stock is the underlying asset of the option. Mathematically the stock
is the independent variable, and the option is the dependent variable (see Fig. 8.4).
However, the call embedded in CB is the right to acquire a predetermined number
of the stock per unit. Thus CB has a moving conversion price. Furthermore, an
option on a CB consists in general of more than one stock. For calculating the price
of a convertible, a model has to be applied.
8.4 The Embedded Call Option 179
PCB
180
160
140 CV before expiration

CV at expiration
120
100
80
0 50 100 150 200
stock price
Fig. 8.4 Modelling a CB
Definition 8.10 A sensitivity analysis examines the price behavior of a financial

instrument with respect to a change of a variable that influences its price.
Sensitivity measures are not risk measures. They are used for the analysis of a
particular scenario. They are widely used for different financial instruments.
As discussed in Sect. 3.4, modified duration is a sensitivity measure for a straight
bond. By the modified duration, the following question can be answered. By
changing the interest, we examine the change of price of the bond. The modified
duration is often approximated, although the price formulae of a straight bond can
be explicitly derived.
The capital asset price model (CAPM) (see, e.g., [1]) yields a sensitivity analysis
for equity market. It discusses sensitivity of an equity or a portfolio of equities with
respect to the market. This sensitivity measurement is calculated by historical data.
In the elementary option theory and in analysis of CB, the sensitivities are in
mathematically terms derivatives of the price function and are denoted by Greek
letters.
Definition 8.11 Δ (capital delta) measures the price change of the convertible bond
(PCB) in continuous time versus an infinitesimal change in S
∂ PCB
Δ¼ : ð8:4:1aÞ
∂S
As illustrated by the stock and convertible price graph in Fig. 8.5, Δ is the slope
of the tangent in a specific stock price. For declining stock prices, Δ approaches
0, and for rising stock prices, Δ approaches 1.
Remark: 8.7 The modified duration is based on the linearization of the price-yield
relationship, and Δ is based on the linearization of the convertible bond-stock
relationship.
180 8 Convertible
PCB
180
160
140
CV before expiration
120 Linearization
100
80
0 50 100 150 200
Stock Price
Fig. 8.5 Linearization
Fig. 8.6 Convexity
Definition 8.12 Γ (capital gamma) measures the change of an infinitesimal change

of delta
2
∂ PCB
Γ¼ : ð8:4:1bÞ
∂S2
A convertible bond has positive convexity, i.e., Γ is positive. For decreasing and
for increasing stock prices, Γ approaches 0. Considering opposite swing of the
underlying stock (ΔS) of the same size, the loss on the downside (ΔPCB2) is always
smaller than the gain on the upside (ΔPCB1) (see Fig. 8.6). Thus, convertibles are
asymmetric and reflect the saying that convertibles reflect the best of all worlds.
8.4 The Embedded Call Option 181
Remark: 8.8 The notion convexity in connection with a straight bond is based on
the price-yield relationship, and in connection with a convertible, the notion
convexity is based on the convertible bond-stock relationship.
The stock price is the predominated underlying variable. The stock price is the
only stochastic variable. The term stochastic occurs in a wide variety of profes-
sional or academic fields. It describes events or systems that are unpredictable due
to the influence of a random variable. The word “stochastic” comes from the Greek
word “aim.” In basic option theory, there are five sensitivities. As they are not based
on a stochastic variable, the following sensitivities are rather called parameters.
Definition 8.13 Λ (capital lambda) measures the change in the convertible price in
continuous time versus an infinitesimal change in the volatility σ
∂ PCB
Λ¼ : ð8:4:1cÞ
∂σ
Definition 8.14 θ (capital theta) measures the change in the convertible price in
continuous time versus an infinitesimal change in the time to maturity T
∂ PCB
Θ¼ : ð8:4:1dÞ
∂ ð t TÞ
Definition 8.15 ρ (small rho) measures the change in the convertible price in
continuous time versus an infinitesimal change in riskless interest rate rf
∂ PCB
ρ¼ : ð8:4:1dÞ
∂rf
The Black-Scholes formula electrified the derivative world in 1973. It is a
solution of the heat equation tackled in Physics. In applied mathematics, we
speak a partial differential equation. The boundary condition of this partial equation
is the payout of a call option at maturity (see Appendix K). However, the Black-
Scholes formula cannot be squeezed in pricing convertibles because the Black-
Scholes equation is based on the following assumptions:
• The option is European style, i.e., the option cannot be exercised during the life
of the option.
• There are no cash flows during the life of the option.
Remark 8.9 The Black-Scholes formulae and the sensitivity of Black-Scholes

formulae are in Appendix K. The Black-Scholes formulae can be seen as first
approach for pricing a CB; however, for pricing the different specific features of
a CB, the model has to be refined. In most cases, there are no closed formulae. The
182 8 Convertible
Market data Greeks
Convertible Bond Market Price
Static data Theoretical Price
Fig. 8.7 Inputs and outputs
price can only be computed numerically, and the sensitivities have to be

approximated by finite difference (Appendix D).
In Fig. 8.7, we describe the input and the output of a CB. As discussed in the
introduction, we distinguish market data and static data. Market data are the
interest rate, credit market, equity market price, the conversion price, and conver-
sion premium, and the static data are in the prospectus of a CB like the coupon,
conversion ratio, and conversion price. Outputs are a theoretical price, a potential
market price and Greeks.
Valuation or pricing a CB is an important but also a difficult task for a portfolio.
Only to price the embedded call option on a CB is challenging. The theoretical price
is used for:
• Performing a scenario analysis. The behavior of the CB has to be computed

under assumed shocks of different underlying variables that influence the price.
• Approximating the sensitivities. A closed formula of a CB in most cases is not
available, and the derivatives in (2) have to be approximated by finite differences
(Appendix D).
• Determining whether a CB is rich or cheap relative to the price paid in the
market (relative value analysis).
The Black-Scholes has to be generalized to a model that reflects, for instance, the
following features of the CB:
• Including American style option, i.e., the option can be exercised during the life
of the option
• Reflecting the coupon of the CB and prospective dividends of the underlying stock
• Modelling call and put provision in a CB
References 183
There is a vast literature of modelling CBs (see, e.g., [2]).

Figure 8.4 shows the price of the CB before the time of maturity and at the time
of maturity. On the y axis, we have the stock price multiplied by the conversion
factor. It tracks the upward changes in the price of the underlying stock yet is
cushioned by the bond floor as the stock declines. In case of equity prices going up,
the convertible is priced very similarly to its underlying equity. Conversely, when
the underlying stocks are far below the conversion value, convertibles perform
more like a straight bond. Thus, convertibles generally provide the greatest advan-
tage to investors when they are in the middle range of the fair value price track
providing a combination of equity upside potential and bond-like downside
protection.
References
2. de Spiegeleer J, Schoutens W (2011) The handbook of convertible bonds. Wiley, Hoboken, NJ
Appendices
Appendix A (Closed Formula for the Geometrical Series)
For an ordinary annuity with unity cash flow q ∈ R1, q 6¼ 1, we have
1 qNþ1
sNOA ¼ q1 þ q2 þ . . . þ qNþ1 ¼ q , N ¼ 0, 1, 2, . . . : ðA:1aÞ
1q
For q ¼ 1þr
1
we have
Nþ1
1 1
sNOA ¼ þ ... þ
1þr 1þr
1 1
1 Nþ1
1 ðA:1bÞ
1 ð1 þ rÞ ð1 þ rÞNþ1
¼ ¼ :
ð1 þ r Þ 1 r
1
1þr
For q ¼ 1
sNOA ¼ q þ q2 þ . . . þ qNþ1 ¼ N q: ðA:1cÞ
Remark The numeration does not correspond to our notation of the time axes (see
Remark 3.1) as we have N ¼ 0 is t1 ¼ 1.
Verification:
1 1þr
1 1þr1 r
1
N ¼ 0 : s0OA ¼ ¼ 1þr ¼ 1þr ¼ :
r r r 1þr

W. Marty, Fixed Income Analytics, DOI 10.1007/978-3-319-48541-6
186 Appendices
2
1 ð1 þ rÞ2 1 1 þ 2r þ r2 1 2r þ r2
1
1þr ð1 þ r Þ ð1 þ rÞ ð1 þ r Þ
2 2 2
N ¼ 1 : s1OA ¼ ¼ ¼ ¼
r r r r
2þr 1þ1þr 1 1
¼ ¼ ¼ þ :
ð1 þ r Þ2 ð1 þ rÞ2 1 þ r ð1 þ r Þ2
For an annuity due with unity cash flow q ∈ R1, q 6¼ 1, we have
sNAD ¼ q0 þ q1 þ . . . þ qN ¼ 1 þ q1 þ . . . þ qN
1 qNþ1 ðA:2aÞ
¼ : N ¼ 0, 1, 2, . . . :
1q
For q ¼ 1þr
1
, r > 0, we have
1 1
N 1 Nþ1 1þr
1 1 ð1 þ rÞ ð1 þ r ÞN
sNAD ¼ 1þ þ ... þ ¼ ¼ :
1þr 1þr 1 r
1
1þr
ðA:2bÞ
And for q ¼ 1, we have
q þ q2 þ . . . þ qNþ1 ¼ ðN þ 1Þ q:
A perpetual annuity is an infinite series and we have for | q | < 1
1
1 þ q þ . . . þ qN þ qNþ1 þ : . . . :þ ¼ ðA:3Þ
1q
Remark The numeration does correspond to our notation of the time axes: N ¼ 0
is t0 ¼ 0.
Verification:
N ¼ 0: s0AD ¼ 1
1 ð1 þ rÞ2 1 1 þ 2r þ r2 1 2r þ r2
1 2þr
N¼1: ¼ 1
s1ADþ r ¼ 1þr ¼ 1þr ¼ 1þr ¼
r r r r 1þr
1þ1þr 1
¼ ¼1þ :
1þr 1þr
Appendices 187
Appendix B (Landau Symbol)
Let f and g two real value function defined in the neighborhood of x0.
(a) The little Landau symbol o
f ðxÞ ¼ oðgðxÞÞ, x ! x0 ðB:1Þ
is defined by
j f ð xÞ j
lim ¼ 0:
x!x0 j gðxÞ j
(b) The big Landau symbol O
f ðxÞ ¼ OðgðxÞÞ, ðB:2Þ
is defined by the inequality with C ∈ R1
j f ðxÞ j Cj gðxÞ j:
Appendix C (Application of the Landau Symbol to the Taylor

Series)
From the calculus we know that if all the derivatives of f(x) up to order n + 1 at least
exist at a point x0 there of an interval, then there is a number ξ between x0 and any
point x of the interval such that
00
f ð x0 Þ ð x x0 Þ 2 f ðnÞ ðx0 Þðx x0 Þn
f ð xÞ ¼ f ð x0 Þ þ f 0 ð x0 Þ ð x x0 Þ þ þ ... þ þ Rn
2! n!
where the remainder Rn is given by
f ðnþ1Þ ðξÞðx x0 Þnþ1

Rn ¼ :
ðn þ 1Þ!
In finance we mostly look at n ¼ 0 or n ¼ 1. The case n ¼ 0 is called the law of

the mean or mean value theorem for derivatives.
f ðxÞ ¼ f ðx0 Þ þ ðx x0 Þ f 0 ðξÞ:

188 Appendices
By (B.1) we have
f ðxÞ ¼ f ðx0 Þ þ Oððx x0 ÞÞ:
By (B.2) we have
f ðxÞ ¼ f ðx0 Þ þ ðx x0 Þ f 0 ðξÞ þ oððx x0 ÞÞ:
The case n ¼ 1 is
00
f ð x0 Þ ð x x0 Þ 2
f ð xÞ ¼ f ð x0 Þ þ ð x x0 Þ f 0 ð x0 Þ þ :
2!
By (B.1) we have
f ðxÞ ¼ f ðx0 Þ þ Oððx x0 ÞÞ:
By (B.2) we have
f ðxÞ ¼ f ðx0 Þ þ ðx x0 Þ f 0 ðξÞ þ oððx x0 ÞÞ:
Appendix D (Finite Differences):
The first derivative of f in x0 is defined by
f ðx0 þ hÞ f ðx0 Þ
f 0 ðxÞ ¼ lim : ðD:1Þ
h!0 h
The first derivative of the function f is approximated by function value of f as
follows:
(a) By using the central difference in the neighborhood of x0
f ðx0 þ hÞ f ðx0 hÞ
then the first derivative of f is then approximated in the neighborhood x0
f ð x0 þ hÞ f ð x0 hÞ
f 0 ð xÞ ¼ þ OðhÞ ðD:2Þ
2h
or analogously
f ð x0 þ hÞ f ð x0 hÞ 00
f 0 ðxÞ ¼ þ h f ð x0 Þ þ o h2 :
2h
Appendices 189
(b) By using the backward difference in the neighborhood x0 of
f ðx0 þ hÞ f ðx0 Þ
the first derivative of f is then approximated in the neighborhood x0 by
f ð x0 þ hÞ f ð x0 Þ
f 0 ðxÞ ¼ þ OðhÞ ðD:3Þ
h
or analogously
f ðx0 þ hÞ f ðx0 hÞ h 00
f 0 ðxÞ ¼ þ f ð x0 Þ þ o h2 :
2h 2
(c) By using the forward difference in the neighborhood of x0 is
f ð x0 Þ f ð x0 hÞ
the first derivative of f is then approximated the neighborhood x0 by
f ð x0 Þ f ð x0 hÞ
f 0 ð xÞ ¼ þ OðhÞ, ðD:4Þ
h
or analogously
f ð x0 þ hÞ f ð x0 hÞ 00
f 0 ðxÞ ¼ þ h f ð x0 Þ þ o h2 :
2h
The second derivative of f is approximated by (B.3)
00 f 0 ð x0 þ hÞ f 0 ð x0 hÞ
f ð xÞ ¼ þ OðhÞ:
2h
By using (D.1) and (D.2), we have by expressing the second derivative by
function value
00 f ðx0 hÞ 2f ðx0 Þ þ f ðx0 þ hÞ

f ð xÞ ¼ þ O ð hÞ
2h2
or analogously
f ðx0 hÞ 2f ðx0 Þ þ f ðx0 þ hÞ h 000

2
þ f ðx0 Þ þ o h2 :
2h 6
190 Appendices
Appendix E (Integral, Riemann Sum)
As illustrated in Fig. E.1, we consider a function f(x) defined on the interval [a, b]
and a partition
x0 ¼ a, : . . . , xk < xk1 , : . . . , xN ¼ b
of the interval [a, b]. By integrating the function, we mean calculating the area
beneath and above the function f(x). We define
m k ðf Þ ¼ min f ð xÞ
x ∈ ½xk ;xkþ1
and
M k ðf Þ ¼ max f ð xÞ
x ∈ ½xk ;xkþ1
and
hk ¼ xk xκ1 :
We consider the estimation
X
N ðb X
N
mk ðf Þ hk f ðxÞdx M k ð f Þ hk
k¼1 k¼1
a
and the integral is the defined
ðb X
N X
N
f ðxÞdx ¼ lim Mk ðf Þ hk ¼ lim m k ð f Þ hk :
hk !0 hk !0
k¼1 k¼1
a
The integration is an abbreviation for an infinite sum.
Fig. E.1 Integration of a f(x)

function
mk Mk
x
a = x0 xk x k+1 b = x0
Appendices 191
Appendix F (Linear Interpolation)
NAVðr2 Þ NAVðr1 Þ
NAVðrÞ ¼ NAVðr1 Þ þ ðr r1 Þ:
r2 r1
The condition NAV(r) ¼ 0 leads to
NAVðr2 Þ NAVðr1 Þ
0 ¼ NAVðr1 Þ þ ðr r1 Þ:
r2 r1
which leads to the zero r0
NAVðr1 Þ
r0 ¼ r2
NAVðr2 Þ
Appendix G (The Closed Formulae of the Macaulay Duration)
Assuming that r > 1, r ∈ R1 a closed formula for Macaulay duration is [1]

C α þ 1r ½ð1 þ rÞn 1 Cn þ F ðn 1 þ αÞr
Dmac ¼ : ðG:1Þ
C ðð1 þ rÞn 1Þ þ Fr
With α ¼ 1 we have

1
C 1 þ ½ð1 þ rÞn 1 Cn þ F nr
r
DMac ¼ n
C ðð1 þ rÞ 1Þ þ Fr
C 1 C
1 þ ½ð1 þ rÞn 1 n þ F n
r r r
¼
C n
ð ð 1 þ r Þ 1Þ þ F
r
C 1 1 C F
1þ 1 n nn þ n
r r ð1 þ r Þ r ð1 þ r Þ ð1 þ r Þn
¼ :
C 1 F
1 þ
r ð1 þ r Þn ð1 þ rÞn
We claim
Xn
1 1 1 n j
1þ 1 n n ¼ : ðG:2Þ
r r ð1 þ r Þ rð1 þ rÞ j¼1 ð1 þ rÞ
j
192 Appendices
and we adopt a proof by induction with respect to n. For n ¼ 1 we find

1 1 1 1 1 1 1 1
1þ 1 ¼ 1þ 1
r r 1þr rð1 þ rÞ r r 1þ r 1þ r
1 rþ1 r 1
¼
r r 1 þ r 1þr
1 1 1 r
¼ 1 ¼
r 1þr r1 þ r
1
¼ :
1þr
We assume the assertion (2) for n and consider the following algebraic
reformulations

1 r 1 n nþ1
1 n nþ
r 1þr ð1 þ rÞ rð1 þ rÞ ð1 þ rÞnþ1

1 1 1 n n 1
¼ 1þ 1 þ þ
r r ð1 þ rÞn rð1 þ rÞn ð1 þ rÞnþ1 ð1 þ rÞnþ1

1 1 1 1 n n
¼ 1þ 1 n þ nþ
r r ð1 þ r Þ ð1 þ r Þ nþ1 ð1 þ rÞ ð1 þ rÞnþ1

1 1 1 1 1
¼ 1þ 1 þ þ
r r ð1 þ rÞn ð1 þ r Þ nþ1
rð1 þ rÞnþ1

1 n n 1 1 1
n þ ¼ 1 þ 1
rð1 þ rÞnþ1 ð1 þrÞ ð1 þ rÞnþ1 r r ð1 þ rÞn
1 1 1
þ nþ1
1þ ð1 þ nð1 þ rÞ nrÞ
ð1 þ r Þ * r rð1 þ rÞnþ1 +

1 1 1 r nþ1
¼ 1þ 1 nþ
r r ð1 þ rÞ ð1 þ r Þnþ1
rð1 þ rÞnþ1
* +
1 1 ð1 þ rÞnþ1 1 r þ r nþ1
¼ 1þ nþ1

r r ð1 þ r Þ rð1 þ rÞnþ1
* +
1 1 1 nþ1
¼ 1þ 1 :
r r ð1 þ rÞnþ1 rð1 þ rÞnþ1
Thus (2) is shown for n + 1 and the assertion (2) is verified. In order to show
expand (2) to 0 < α < 1, we consider with (1)
Appendices 193

1 1 1 n 1 1 1 n
αþ 1 ¼ 1þ 1 n
r r ð1 þ rÞn ð1 þ rÞn r r ð1 þ r Þ ð r Þ
1 þ n
1 1 1 n
1þ 1 þ
r r ð1 þ rÞn ð1 þ rÞn
1 1 1 n
þ αþ 1
r r ð 1 þ rÞ n ð 1 þ rÞ n
X n
j 1 1
¼ þ h α 1 i 1
j¼1 ð1 þ rÞ
j r ð1 þ rÞn
X n
jþα1
¼ j
:
j¼1 ð1 þ rÞ
Thus (1) is shown.
Appendix H (A Closed Formula for Convexity)
The concept of duration and convexity are important for investigating the price
behavior of fixed-income instruments. They are widely described in literature (see
e.g. [1]). There are two types of duration. Macaulay duration is defined as the
average life of a bond and modifies duration DMod
Dmac ¼ ð1 þ rÞ Dmod : ðH:1Þ
We start by
dP
Dmod ¼ dr , ðH:2Þ
P
d2 P
dr2
Co ¼ ðH:3Þ
P
where d denotes the derivative of the price P with respect to r. (G.1) is the same as
C ð1 þ αrÞ ð1 þ rÞn ð1 þ rÞ ðn 1 þ αÞr

ðn 1 þ αÞ þ Fðn 1 þ αÞ
1þr
Dmac ¼ : ðH:4Þ
P
For r ¼ 0 we have

n nþ1
C þ1
2
Dmac ¼ :
Cn þ 1
194 Appendices
From (2) we have
dP
¼ Dmod P ðH:5Þ
dr
Convexity is defined by
1 d2 P
Co ¼
IP dr2
By assuming that IP ¼ P we find (H.1) and (H.5)
1 d dDmod Dmac
Dmod
Co ¼ ðDmod PÞ ¼ ðDmod Þ2 ¼ ðDmod Þ2 dr
IP dr dr 1þr
In order to calculate Ddrmac , we consider
Z
Dmac ¼
P
dDmac dDdrmac P Z dP dDmac

P þ ZDmod P
¼ 2
dr
¼ dr :
dr P P2
We find the following algorithm for computing the convexity Co:
1. Calculate DMod by (H.4) and (H.1).

2. Calculate dZ
dr we find
1 dZ 1 ð1 þ α þ nÞ þ α ð1 þ rÞn n ð1 þ rÞ1þn ðn αrÞr

¼
c dr r2 ð1 þ rÞðn1þαÞ
2ð1 r ð1 þ α þ nÞr þ ð1 þ rÞn ð1 þ αrÞÞ

r3 ð1 þ rÞðn1þαÞ
ð1 þ α þ nÞð1 þ rÞ1ð1þαþnÞ ð1 r ð1 þ α þ nÞ r þ ð1 þ rÞn ð1 þ αrÞÞ
r2
1 2 1ð1þαþnÞ
ð1 þ α þ nÞ ð1 þ rÞ
c
3. Compute the convexity by
1 d2 P 1 dZ dr P þ ZDmod P
¼ ð D Mod Þ Dmod
P dr 2 ð1 þ rÞ P2
Appendices 195
Appendix I (Cubic Splines)
We show that the splines are twice differentiable in the knots for t ¼ tk we have
based on (4.3.8)

ðtk tk1 Þ2
f j ðtÞ
t¼tk ¼
6
on (4.3.9) as e ¼ 0, we have

c2 ce e2 e3
c2
f j ðtÞ
¼ þ þ
¼
t¼tk
t¼tk 6
for the derivative we have (4.3.8)

* +
df k
3ðtk tk1 Þ2
tk tk1

¼
¼
dt t¼tk 6ðtk tk1 Þ
2
t¼tk

df j
þ c 3e2

tk tk1

¼ þe ¼
dt t¼tj 2 6ðtkþ1 tk Þ
t¼tk 2
for the second derivative, we have

* +
d2 f k
6ðtk tk1 Þ2
¼
¼1
d2 t t¼tk 6ðtk tk1 Þ
t¼tk
d2 f j
þ
¼ 1:
d2 t t¼tk
and for t ¼ tk+1, we have
c2 ce e2 e3
f j ðtÞ ¼ þ þ
c ¼ tk tk1 ¼ B A
e ¼ t tk ¼ tkþ1 tk ¼ C B
c2 ce e2 e2 c2 ce e2
f j ðt Þ ¼ þ þ ¼ þ þ
6 2 2 6 6 2 3
196 Appendices
This the same to

c2 þ ce þ 2e2 ðB AÞ2 þ 3ðB AÞðC BÞ þ 2ðC BÞ2

f j ðt Þ
t¼tjþ1 ¼ ¼
6 6
BB 2BA þ AA þ 3BC 3AC 3BB þ 2CC 2CB þ 2BB
¼
6
2BA þ AA þ BC 3AC þ 3AB þ 2CC
¼
6
AA þ BC 3AC þ AB þ 2CC
¼ f j ðtÞ
þt¼tkþ1
6

2tkþ1 tk tk1 ðC AÞð2C B AÞ
¼ ðtkþ1 tk1 Þ ¼
6 6
2CC 2CA BC þ AB AC þ AA
¼ :
6
For the derivative we have (4.3.8)

df k
c 3e2

¼ þe
dt t¼tkþ1 2 6ðtkþ1 tk Þ
t¼tkþ1
1 1
¼ ðtk tk1 Þ þ ðtk tk1 Þ þ ðtk tk1 Þ
2 2
1
¼ ðtkþ1 tk1 Þ
2

df j
þ 1

¼ ðtkþ1 tk1 Þ
dt t¼tkþ1 2
for the second derivative, we have

d2 f j
e
2
t¼tkþ1
¼ 1 ¼0
d t ðtkþ1 tk Þ
t¼tkþ1
d2 f k
þ

¼0
d2 t t¼tkþ1
Appendix J (See Also [2])
1 ðxμÞ 2
f ðxÞ ¼ pffiffiffiffiffiffiffiffiffiffi e 2σ2 ,
2πσ2
Appendices 197
We use the following notions:
• μ: n 1 vector of expectation values.

• S: n n covariance matrix of the historical return.
• R is a rectangular matrix, i.e., R ∈ Rnm, with uncorrelated random numbers of
normally distributed with μ ¼ 0 and numbers.
Starting from the definition of the covariance matrix V,

V ¼ E XXT EðXÞE XT :
A Cholesky factorization L of the known covariance matrix S is
S ¼ LLT :
We consider the product of the random matrix R and L
Z ¼ LR
and calculate the covariance of Z:

VðLRÞ ¼ E ðLRÞ LRT EðLRÞEðLRÞT
¼ E LRRT LT EðLRÞE RT LT :
Remember that L is a constant matrix in respect to the expectation operator and

for constant c ∈ R1:
EðcXÞ ¼ cEðXÞ:
Then we have

VðLRÞ ¼ L E RRT EðRÞE RT LT
¼ LEðEÞLT :
The expected value of E is the identity matrix I:

L $ N ð0; 1Þ , LðEÞ ¼ I
L is the Cholesky factorization of S:
VðLRÞ ¼ LILT ¼ LLT ¼ S:
We have shown that the covariance matrix of LE is S:
V ðLRÞ ¼ S:
It is trivial to add expected values μ to Z in an additional step.

198 Appendices
Appendix K (Derivation of Black-Scholes Differential Equation)
We suppose that the stock price denoted by S follows the process
dS
¼ μ dt þ σ dz: ðK:1Þ
S
The first term contains the expected return μ, and the second term is the risk term
represented by the volatility σ. It assumed to be a Wiener process. Following Ito
Lemma there exists a C(S, t) with
!
2
∂C ∂C 1 ∂ C 2 2 ∂C
dC ¼ μS þ þ σ S dt þ σSdz: ðK:2Þ
∂S ∂t 2 ∂S 2 ∂S
The discrete version of (1) and (2) over the time interval Δt is
ΔS
¼ μΔt þ σΔz ðK:3Þ
S
!
2
∂C ∂C 1 ∂ C 2 2 ∂C
ΔC ¼ μS þ þ σ S Δt þ σSdz: ðK:4Þ
∂S ∂t 2 ∂S2 ∂S
Consider the portfolio

that consists of 1 of the call option C and
∂C
of shares,
∂S
and define the value π of the portfolio by
ΔC
π ¼ C þ S: ðK:5Þ
S
Over a interval Δt yields
∂C
Δπ ¼ ΔC þ ΔS ðK:6Þ
∂S
and by (3) and (4) in (6), we have
!
2
∂C 1 ∂ C 2 2
Δπ ¼ σ S Δt: ðK:7Þ
∂t 2 ∂S2
Appendices 199
No risk term dz [see (1)], that is π, must earn in accordance to the risk free rate rf
Δπ ¼ rf π Δt:
(5) and (7) give

!
2
∂C 1 ∂ C 2 2 ∂C
þ σ S Δt ¼ rf C S Δt,
∂t 2 ∂S2 ∂S
hence
2
∂C ∂C 1 ∂ C
þ rf S S þ σ 2 S2 2 ¼ rf C: ðK:8Þ
∂t ∂S 2 ∂S
This is the Black-Scholes partial differential equation. The solution is dependent
from a boundary condition. For a call option, this boundary condition is the PO of
the call option (see Fig. K.1). With denoting the strike price by K and
ðx
z2
NðxÞ ¼ e 2 dz
1
the price of a European call option in
CðSÞ ¼ SNðd1 Þ KeT Nðd2 Þ
whereby
S D E D E
r σ2 T ln KS þ r σ2 T
2 2
ln K
d1 ¼ pffiffiffi , d2 ¼ pffiffiffi :
σ T σ T
Call Option
70
60
50
40
30 Call option
Payoff Call
20
10
0
0 50 100 150 200
Stock Price
Fig. K.1 The PO of a call option

200 Appendices
Then sensitivities (Greeks) are then
∂C
Δ¼ ¼ Nðd1 Þ;
∂S
2
∂ C pffiffiffi
Λ¼ ¼ S TN0 ðd1 Þ;
∂σ 2
∂ C N0 ðd1 Þ
2
Γ¼ ¼ pffiffiffi ;
∂σ 2 Sσ T
∂C SN0 ðd1 Þσ
θ¼ ¼ pffiffiffi rf K eT Nðd2 Þ;
∂S 2 T
∂C
ρ¼ ¼ KT erf T Nðd1 Þ:
∂rf
References
1. Fabozzi FJ, Iriving PM (1987) Understanding duration and volatility. In: Kopprasch Robert W
(ed) The handbook of fixed income securities. Chapter 5, 2nd edn. Dow Jones-Irwin,
Homewood, IL, pp 86–120
2. Neil R (2003) Currency overlay. Wiley, Hoboken, NJ

Index
A I
Accrued interest, 20–22, 49, 161 Industry-standard benchmark, 159
Asset swap, 4, 157, 158 Interest rate market risk, 112
Interest rate spread, 129–133, 154
Interest rate swap (IRS), 4, 152–157
B Internal rate of return, 3, 26, 30, 32, 48, 49,
Benchmark bond, 161 55–102, 161
Bootstrapping, 113, 115, 118, 119 Invoice price (IP), 19, 20, 22, 49, 113, 121, 123,
127, 150
C
Capital market, 17, 20, 140, 149 M
Clean price, 20, 21, 49 Macaulay Duration, 32–38, 44, 45, 47–50, 55,
Composite rating, 142–144 77–94, 97, 98, 100, 101, 126, 156
Convertible, 4, 149, 173–183 McCulloch equation, 119, 126
Convexity, 32–55, 145, 180, 181 Modified duration, 3, 49–51, 55, 77, 81–89, 91,
Current yield, 28 127, 132, 152, 179
Money market, 17, 24, 112, 149, 150, 161, 163,
164, 169
D
Direct yield (DY), 28, 29, 57–71, 94, 176
Dirty price, 19 N
Discount bond, 23, 27, 28, 44, 97, 177 Net asset value (NAV), 55–57, 71, 85, 86, 88,
Discount factor, 7–12, 29, 33, 34, 44, 46, 50, 89
57, 58, 71, 76, 96, 103, 107, 111,
118–120, 125, 152, 155
P
Par bond, 27, 28, 59, 60, 64, 65, 67, 77, 80, 85,
E 87, 97, 111, 113, 114, 123, 131, 153
Effective duration, 3, 126–128 Premium bond, 23, 27, 28, 67
F S
Fisher-Weil duration, 126, 128 Simple price, 21
Flat price, 21, 22, 127 Spot rate, 26, 32, 49, 101, 103–127, 131, 153
Flat yield curve, 3, 58, 123 Spread duration, 132, 152
Flat yield curve concept, 3, 17, 99 Straight bond, 1, 4, 17–24, 32, 35, 37, 42, 44,
Forward rate, 103–111 52, 55, 115, 126, 132, 149, 150, 152,
Full price, 19 175–177, 179, 181, 183

204 Index
T Yield to maturity (YTM), 3, 25–29, 32, 35–37,

Tailor-made benchmarks, 160 49, 57, 58, 60, 64, 66, 71, 76, 78–82, 89,
Term structure, 3 90, 101, 103, 104, 106, 114, 115, 118,
126, 129–131, 145, 146, 176, 177
Y
Yield curve, 2–4, 17, 45, 95, 96, 98, 103, 106, Z
110–126, 131, 132, 147, 149, 150, 154, Zero coupon bond, 18, 26, 29, 32, 104, 106,
156 113

Fixed Income Analytics - Bonds in High and Low Interest Rate Environments

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Wolfgang

ISBN 978-3-319-48540-9 ISBN 978-3-319-48541-6 (eBook)

Library of Congress Control Number: 2017952064

# Springer International Publishing AG 2017

Printed on acid-free paper

This Springer imprint is published by Springer Nature

In light of an investment environment characterized by low yields and new regu-

Chairman and Founder AgaNola AG Stefan Hiestand

Head of Quantitative Research Dr. Jan Hendrik Witte

Pfaeffikon SZ, Switzerland Wolfgang Marty

6 Different Fixed Income Instruments . . . . . . . . . . . . . . . . . . . . . . . . . 149

Wolfgang Marty is senior investment strategist at AgaNola, Pfaeffikon SZ,

A fixed-income security is a financial obligation of an entity that promises to pay a

# Springer International Publishing AG 2017 1

coupon coupon coupon coupon Original time

Fig. 1.1 Straight bonds

Outstanding U.S. Bond Market Debt

Fig. 1.2 The development of the US bond market

• The transition from a single bond to portfolio of bonds is examined. We

Fig. 1.3 Different interest

used for a sensitivity analysis of a bond portfolio. The different durations we

2.1 The Return Over a Time Unit

EV1 ¼ BVð1 þ rÞ ð2:1:1Þ

• We hold the beginning value over one year.

Example 2.1 We consider for BV a Coupon C of an annual paying bond. Then

# Springer International Publishing AG 2017 5

Fig. 2.1 The time unit t1 = 0.25 t3 = 0.75

Here, we have a reinvestment assumption about the middle of the year: we

e ¼ 2:71828 18284 5905:

From calculus we also have

Hence, when compounding with an infinitely small compounding interval, the

EV2 ¼ $105.06250 (semi-annual).

Definition 2.1 The return

Remark 2.1 For discrete compounding, we have

2.2 Discount Factors

By assuming t0 ¼ 0, t0 is the present or for short t0 is now. However, in principle,

Fig. 2.2 The time axis

and for equidistant knots tj ¼ j with rj ¼ r(tj) and tk ¼ 0, the abbreviation

Example 2.4 We choose N ¼ 4 in (1, 2) with a cash flow $3 in t ¼ tN ¼ 4. With

Fig. 2.3 Discount factor ex post and ex ante

Lemma 2.1 In (4) we have under the assumption C > 0:

(b) For fixed C ∈ R1 and t ∈ R1 with t > 0, BV(C, r, t, tk) is a monotonically

• For r > 0, monotonically decreasing and converging with limit 0.

Proof From (4), we have

and by assuming r > 1, we have

i.e., in order to show monotonicity, it is enough to consider

The assertions a and b follow from the partial derivatives

The assertion d follows from induction with respect to n. □

BVðC; C; C=100Þ ¼ 4:364739:

Proof By assumption, we have:

We use the product rule for the derivative

Fig. 2.4 Global maximum

and for the ending value EVor we find

and for the ending value EVdue, we find

Remark 2.3 EV and BV are related by

and for N!1 and r > 0, we have

Example 2.5 For N ¼ 1 in (1a), we have

For N ¼ 1 in (2a), we have

Example 2.6 With C ¼ $150,000 and r ¼ 3%, we have by (3a)

Lemma 2.3 (Repayment of Mortgage) We assume that a BV and an interest r > 0

and for an annuity due, we have

Starting with an initial value BV, we consider the iteration