Investments

Lecture 2.4

What is a forward rate?

Forward rate: Estimated Spot rate of the future. By using the concept of
arbitrage
Forward contract: today at time 0 we don’t exchange any CF, just set
the terms of the contract, the time T (beginning of the forward rate) we
gonna pay 1€, at time T+K gain back the return on our investment
Only used of spot rate of today
Make arbitrage- make up investment strategy that allow make 100%
profit in the future (should not be possible in the financial market but it is)
Suppose that Forward rate is smaller than the formula with the no
arbitrage. We can create an arbitrage strategy that will give 100
% profit. How:
1. Sell the forward contract. Why? The interest rate that we see coted in
the financial market is lower than it should be, by selling to the other part
we going to pay less then we would if we sold in future according to
concept of no arbitrage.
2. Borrow to the bank the present value of 1€ with maturity T. Borrowing
the amount money of the bank it force you to pay at time T (exactly 1€)
3. Invest the amount of money that we borrowed at the current spot rate
from 0 to T +K

How can we get?

In time 0 there’s no profit since we invest the same that we receive from
the bank
At time T: Pay back to the bank the 1$ and we need to receive form the
other part the 1€ that we arrange in the contract
Time T+K: pay the other part but at the same time receive what we
invested. This last equation its zero if the forward rate is equal to the
forward rate calculated with the initial formula (no arbitrage).
Practical Example:

Forward rate incorporates two concepts:

1. Expectation given today information of future sport rates.
2. Risk premium. Investors are willing to receive a higher rate when
enter the forward contract. Not only incorporate the investment
they gave to pay in the future but also taking the risk of changing
on interest rate.

Lecture 3.1 – Interest Rate Risk – Duration

What is Interest Rate Risk

Treasury bonds are supposed to be risk free. But they aren’t. There is the
Interest Rate Risk. For example when we buy a treasury bond but we are
not willing to stay with it until maturity, and if sell in the middle of the
maturity we will need to use, to calculate the Price (the price that will sell
the bond) we will use future forecast rate. However, this rates might
change in the future so there is risk associated with this bond.
Let’s see an example:

We will assume in the exercises of this part that the curve will be flat
which mean that in that case no matter what time the maturity is the
spot rate will always be the same. So we can write YTM because the spot
rates will always be the same.
The same increase in the spot rate (1% up or 1% down) will imply different
changes in the price of the bond. The relation between bond prices and
interest rate are non linear as we can see in the graph above.
Convexity: price decrease for yield increase is smaller than price
increase for equal decrease in yield

How to calculate the interest rate risk

The derivative gave us a negative sign which was already expected
since the relation between interest rates and price bonds is negative.
Duration- unit is time. Amount time that we (as a bond investor) need to
wait to get back in CF the price we have paid for such a bond. Just tells
the time we have to wait to gain at least the price we have paid to get
the bond in the began, however we will probably receive more but
duration just tell us that. It estimate the sensitivity of bond prices to
changes in interest rates.
First order approximation of the interest rate risk
Bonds with longer duration will be more sensitivity of their prices to
changes in interest rates. Because if for example the r starts to get lower
then CF will get bigger and the time to get back what you invest will be
lower.
Bond with higher coupon will have lower sensitivity of their prices to
changes in interest rates then bond with lower coupon payments.

Since we assume the spot rate were the same we will have an
approximation with a flat line. When the changes in the interest rates are
to significant the two lines will distance a lot and this can lead to
significant errors in the calculation of the risk of the interest rate.
• For zero coupon bonds: duration = maturity
• Duration goes down as yields go up
• First-order approximation is symmetric and ignores convexity!

Lecture 3.2 – Interest Rate Risk – Interest Rate Risk -

Convexity and Immunization
How to improve the the distance with the two function? To doing that
we will use the second derivative.
• Duration-based approximation works for small changes in yields.
• For larger swings in yields, use a second-order approximation

The second part of the formula (convexity + Variation of YTM^2) will

always affect the formula positively since there is no negative term in the
convexity formula and the YTM is being ^2. This will helps us to have a
larger increase in bond prices when interest rate decreases then the
corresponding decrease in bond prices when interest rates increase by
the same amount.

Question: everything else constant, do investors like convexity?

• Yes, creates positive skewness in bond’s returns
• Bonds with high convexity therefore have higher prices, ceteris
paribus

How to manage interest rate risk in practice

• Asset-Liability Management (ALM)
‒ Liabilities: long-term pension promises with duration ~20 years
‒ Assets are chosen to match this duration
Duration matching: the duration of your portfolio of assets as to be the
same as the duration of your portfolio of liabilities.
Issues with this technique:
1) We will need to reinvestment CF that we don’t know today
2) Duration based is not precise as we seen before
3) What we assume of the spot rates but in practice the spot rates
don’t change by the same amount.

Lecture 3.3 – Accrued Interest and Default Risk

What other type of fixed income securities are trade in financial markets.
Assuming that we bought the bond in the date 2 (between two
payments of two coupons). I will get the coupon of the date 3 but the
owner before me has the right to gain the portion between date 1 and
date 2 because he held the bond in that period. So the way to solve this
problem is that the buyer will not only pay (included in the price bond)
the coupons we will receive (coupon date 3) – Clean Price but also the
part that the seller would gain which we call Accrued Interest.
Dirty Price- What we actually pay when we buy a bond

1st convention: assumes that every month has 30 day and every year 360
days. Differences between year, month and days that the date we
bought the bond and the date before.
2nd convention: We need a computer this one. The year has 365 and we
have this in account
3rd convention and 4th: (Mix between the first two ones)

Other Fixed Income Securities

Almost all securities incorporate something that the the treasury bond
didn’t. Which is default Risk.
Default Risk: Is the risk that the issuer of fixed income securities will not be
able to pay all the promise CF in the future. This can happen if a
company goes bankruptcy. It is difficult to measure it.