LEVEL AND STRUCTURE OF

INTEREST RATES

Compile by: Achyut Raj Pyakurel

 Term Structure of Interest Rates, Interest Rate
Structure in Nepal,
STUDY CONTENT Interest Rate Fluctuation, Interest Rate Risk and
It's Calculation,
Forward Rates and Their Calculations,
Mortgages and Mortgage Backed Securities,
Interest Rate Derivatives,
Measuring and Managing Risks
TERM STRUCTURE OF INTEREST RATES,
INTEREST RATE STRUCTURE IN NEPAL,
Interest Rate
Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a
borrower for the use of assets.
Interest rates are typically noted on an annual basis, known as the annual percentage rate
(APR).
The rate of interest is the price a borrower must pay to secure scarce loanable funds from a
lender for an agreed- upon time period. It is the price of credit.
High interest rates generally bring forth a greater volume of savings and stimulate savings,
but tend to reduce the volume of borrowing and capital investment.
Lower interest rates on the other hand, tend to dampen the flow of saving and reduce
lending activities, and stimulate borrowing and investment spending.
 TERM STRUCTURE OF
INTEREST RATES
The term structure of interest rates is the relationship between interest
rates or bond yields and different terms or maturities. The relationship
between the rates of return on financial instruments and their maturity is
called the term structure on interest rates.

Term structure may be presented visually by drawing a yield curve for

all securities having the same credit quality.

The term structure of interest rates is also known as a yield curve, and it
plays a central role in an economy. The yield curve considers only the
relationship between the maturity or term of a lean or security and its
yield at one movement in time.
INTEREST RATE STRUCTURE IN NEPAL
INTEREST RATE FLUCTUATION, INTEREST RATE RISK
AND IT'S CALCULATION
Interest rates change over time, reflecting both the demand from borrowers and the
supply of funds available to be loaned by providers of capital.
Why Interest Rates Change?
Economic Growth
Fiscal Policy
Monetary Policy
Inflation
Demand and supply of loanable fund
Investor's expectations
Competitions
Uncertainty
Business growth policy of the BFI's
 INTEREST RATE FLUCTUATION, INTEREST RATE
RISK AND IT'S CALCULATION
Interest rate risk is the potential for investment losses that result from a change in interest rates.
If interest rates rise, for instance, the value of a bond or other fixed-income investment will
decline. The change in a bond's price given a change in interest rates is known as its duration.
Interest rate risk is the potential that a change in overall interest rates will reduce the value of
a bond or other fixed-rate investment:
As interest rates rise bond prices fall, and vice versa. This means that the market price of
existing bonds drops to offset the more attractive rates of new bond issues.
Interest rate risk is measured by a fixed income security's duration, with longer-term bonds
having a greater price sensitivity to rate changes.
Interest rate risk can be reduced through diversification of bond maturities or hedged using
interest rate derivatives.
Formula to compute interest-rate risk: (Original price - new price)/new price.
FORWARD RATES AND THEIR CALCULATIONS

where,
•st: t-period Spot Rate
•st-1:t-1-period Spot Rate
•ft-1, 1: forward Rate applicable for the period (t-1,1)
EXAMPLE #1
THE BONDS ISSUED WITH ONE-YEAR MATURITY HAVE OFFERED A 6.5% RETURN ON INVESTMENT,
WHILE THE BONDS WITH TWO YEARS MATURITY HAVE OFFERED A 7.5% RETURN ON INVESTMENT.
BASED ON THE GIVEN DATA, CALCULATE THE ONE-YEAR RATE ONE YEAR FROM NOW.

Given,
The spot rate for two years, S1 = 7.5%
The spot rate for one year, S2 = 6.5%
No. years for 2nd bonds, n1 = 2 years
No. years for 1st bonds, n2 = 1 year

F(1,1) = [(1 + S1)n1 / (1 + S2)n2]1/(n1-n2) – 1

= [(1 + 7.5%)2 / (1 + 6.5%)1]1/(2-1) – 1
=One year FR one year from now= 8.51%
EXAMPLE #2
THE FIRM HAS PROVIDED THE FOLLOWING INFORMATION. THE TABLE GIVES A SNAPSHOT OF
THE DETAILED CALCULATION OF THE FORWARD RATE.
• SPOT RATE FOR ONE YEAR, S 1 = 5.00%
• F(1,1) = 6.50%
• F(1,2) = 6.00%
BASED ON THE GIVEN DATA, CALCULATE THE SPOT RATE FOR TWO YEARS AND THREE YEARS.
THEN CALCULATE THE ONE-YEAR FORWARD RATE TWO YEARS FROM NOW.

Given, S1 = 5.00%
F(1,1) = 6.50%
F(1,2) = 6.00%
Therefore, the spot rate for two years can be calculated as,
S2 = [(1 + S1) * (1 + F(1,1))]1/2 – 1
= [(1 + 5.00%) * (1 + 6.50%)]1/2 – 1
=Spot Rate for Two Years = 5.75%
CONTD.
Similarly, calculation of spot rate for three years will be,
S3 = [(1 + S1) * (1 + F(1,2))2]1/3 – 1
= [(1 + 5.00%) * (1 + 6.00%)2]1/3 – 1
=Spot Rate for Three Years= 5.67%

Therefore, the calculation of one-year forward rate two years from now will
be,
F(2,1) = [(1 + S3)3 / (1 + S2)2]1/(3-2) – 1
= [(1 + 5.67%)3 / (1 + 5.75%)2] – 1
=one-year forward rate two years from nowF(2 1) is 5.50%
MORTGAGES AND MORTGAGE BACKED SECURITIES
A mortgage is defined as the pledge of physical assets to secure a loan. The physical
assets used to secure the loan is generally in the form of real estate such as land and
building. Such property may be personal property like resident or commercial
property like business apartments.
A mortgage-backed securities (MBS) is a type of security that is secured by
mortgage or collection of mortgage. A mortgage backed security represent an
interest in a pool of mortgage loans.
INTEREST RATE DERIVATIVES (IRDs)
An interest rate derivative is a financial instrument with a value that is linked to the
movements of an interest rate or rates. These may include futures, options, or swaps
contracts.
An interest rate derivative is a financial contract whose value is based on some underlying
interest rate or interest-bearing asset.
These may include interest rate futures, options, swaps, swaptions, and FRA's.
Entities with interest rate risk can use these derivatives to hedge or minimize potential
losses that may accompany a change in interest rates.
IRDs are popular with all financial market participants given the need for almost any
area of finance to either hedge or speculate on the movement of interest rates
INTEREST RATE DERIVATIVES
Types
The most basic subclassification of interest rate derivatives (IRDs) is to
define linear and non-linear.
Linear IRDs are those whose net present values (PVs) are overwhelmingly
(although not necessarily entirely) dictated by and undergo changes
approximately proportional to the one-to-one movement of the underlying
interest rate index.
Examples of linear IRDs are;
Interest rate swaps (IRSs)
Forward rate agreements (FRAs)
Zero coupon swaps (ZCSs)
Cross-currency basis swaps (XCSs) and
Single currency basis swaps (SBSs).
 INTEREST RATE SWAP'S (IRS'S)
An interest rate swap's (IRS's) effective description is a derivative contract, agreed
between two counterparties, which specifies the nature of an exchange of payments
benchmarked against an interest rate index. The most common IRS is a fixed for floating swap,
whereby one party will make payments to the other based on an initially agreed fixed rate
of interest, to receive back payments based on a floating interest rate index. Each of these
series of payments is termed a "leg", so a typical IRS has both a fixed and a floating leg.
 Interest rate swaps are used to hedge against or speculate on changes in interest rates.

 Interest rate swaps are also used speculatively by hedge funds or other investors who expect a
change in interest rates or the relationships between them. Traditionally, fixed income investors
who expected rates to fall would purchase cash bonds, whose value increased as rates fell.
Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates
fall, investors would pay a lower floating rate in exchange for the same fixed rate.

 Interest rate swaps are also popular for the arbitrage opportunities they provide. Varying levels
of creditworthiness means that there is often a positive quality spread differential that allows
both parties to benefit from an interest rate swap.
FORWARD RATE AGREEMENT'S (FRA'S)
A forward rate agreement's (FRA's) effective description is a cash for difference derivative
contract, between two parties, benchmarked against an interest rate index. That index is
commonly an interbank offered rate (-IBOR) of specific tenor in different currencies, for
example LIBOR in USD, GBP, EURIBOR in EUR or STIBOR in SEK. An FRA between two
counterparties requires a fixed rate, notional amount, chosen interest rate index tenor and
date to be completely specified
FRAs are not loans, and do not constitute agreements to loan any amount of money on an
unsecured basis to another party at any pre-agreed rate. Their nature as an IRD product
creates only the effect of leverage and the ability to speculate, or hedge, interest rate risk
exposure
Many banks and large corporations will use FRAs to hedge future interest or exchange rate
exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges
against the risk of falling interest rates. Other parties that use Forward Rate Agreements are
speculators purely looking to make bets on future directional changes in interest rates
ZERO COUPON SWAP (ZCS)
A Zero coupon swap (ZCS) is a derivative contract made between two parties with terms
defining two 'legs' upon which each party either makes or receives payments. One leg is the
traditional fixed leg, whose cashflows are determined at the outset, usually defined by an
agreed fixed rate of interest. A second leg is the traditional floating leg, whose payments at
the outset are forecast but subject to change and dependent upon future publication of the
interest rate index upon which the leg is benchmarked.
This is same description as with the more common interest rate swap (IRS). A ZCS differs from
an IRS in one major respect; timings of scheduled payments. A ZCS takes its name from a zero
coupon bond which has no interim coupon payments and only a single payment at maturity. A
ZCS, unlike an IRS, also only has a single payment date on each leg at the maturity of the
trade. The calculation methodology for determining payments is, as a result, slightly more
complicated than for IRSs.
CROSS-CURRENCY SWAP'S (XCS'S)
A cross-currency swap's (XCS's) effective description is a derivative contract, agreed
between two counterparties, which specifies the nature of an exchange of payments
benchmarked against two interest rate indexes denominated in two different currencies. It also
specifies an initial exchange of notional currency in each different currency and the terms of
that repayment of notional currency over the life of the swap.
(Floating v Floating) Cross-Currency Swaps: are the normal, interbank traded products.
(Fixed v Floating) Cross-Currency Swaps: are a common customization of the benchmark
product, often synthesized or hedged by market-makers by trading a float v float XCS and a
standard interest rate swap (IRS) to convert the floating leg to a fixed leg.
(Fixed v Fixed) Cross-Currency Swaps: a less common customization, again synthesized by
market makers trading two IRSs in each currency and a float v float XCS.
Mark-to-Market or Non Mark-to-Market: the MTM element and notional exchanges are
usually standard (in interbank markets) but the customization to exclude this is available.
Non-deliverable Cross-Currency Swap (NDXCS or NDS): similar to a regular XCS, except
that payments in one of the currencies are settled in another currency using the prevailing FX
spot rate.
INTEREST RATE DERIVATIVES
Non-linear IRDs form the set of remaining products. Those whose present values(pv's)
are commonly dictated by more than the one-to-one movement of the underlying
interest rate index.
These products' pvs are reliant upon volatility so their pricing is often more complex as
is the nature of their risk management
Examples of non-linear irds are;
Swaptions,
Interest rate caps and floors and
Constant maturity swaps (cmss).
SWAPTION
A swaption is an option granting its owner the right but not the obligation to enter into an
underlying swap. Although options can be traded on a variety of swaps, the term "swaption"
typically refers to options on interest rate swaps.
There are two types of swaption contracts (analogous to put and call options):
A payer swaption gives the owner of the swaption the right to enter into a swap where they
pay the fixed leg and receive the floating leg.
A receiver swaption gives the owner of the swaption the right to enter into a swap in which
they will receive the fixed leg, and pay the floating leg.
In addition, a "straddle" refers to a combination of a receiver and a payer option on the same
underlying swap.
The buyer and seller of the swaption agree on:
The premium (price) of the swaption
Length of the option period (which usually ends two business days prior to the start date of
the underlying swap),
SWAPTION
The terms of the underlying swap, including:
Notional amount (with amortization amounts, if any)
The fixed rate (which equals the strike of the swaption) and payment frequency for the fixed leg
The frequency of observation for the floating leg of the swap (for example, 3 month Libor paid quarterly)
There are two possible settlement conventions. Swaptions can be settled physically (i.e., at expiry the swap is
entered between the two parties) or cash-settled, where the value of the swap at expiry is paid according to a
market-standard formula.

There are three main styles that define the exercise of the Swaption:
European swaption, in which the owner is allowed to enter the swap only at the start of the
swap. These are the standard in the marketplace.
Bermudan swaption, in which the owner is allowed to enter the swap on multiple specified
dates, typically coupon dates during the life of the underlying swap.
American swaption, in which the owner is allowed to enter the swap on any day that falls
within a range of two dates
INTEREST RATE CAPS AND FLOORS

An interest rate cap is a type of interest rate derivative in which the buyer receives payments
at the end of each period in which the interest rate exceeds the agreed strike price. An
example of a cap would be an agreement to receive a payment for each month
the LIBOR rate exceeds 2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives payments
at the end of each period in which the interest rate is below the agreed strike price.
Caps and floors can be used to hedge against interest rate fluctuations.
CONSTANT MATURITY SWAPS
A constant maturity swap, also known as a CMS, is a swap that allows the purchaser to fix
the duration of received flows on a swap.
The floating leg of an interest rate swap typically resets against a published index. The
floating leg of a constant maturity swap fixes against a point on the swap curve on a
periodic basis.
A constant maturity swap is an interest rate swap where the interest rate on one leg is reset
periodically, but with reference to a market swap rate rather than LIBOR. The other leg of
the swap is generally LIBOR, but may be a fixed rate or potentially another constant
maturity rate. Constant maturity swaps can either be single currency or cross currency
swaps.
MEASURING AND MANAGING RISKS
Sources of Interest-Rate Risk
1. Maturities mismatching of balance sheet and off-balance sheet items, which we can
define as a non-alignment in the maturity (in the case of fixed interest rates) and
revaluation (in the case of variable interest rates) of assets, liabilities and off-balance sheet
instruments
2. Basis value risk which is connected with the imperfect correlation in the adaptation of
interest rates to assets and liabilities with otherwise similar maturities and revaluation. In the
case of a change in an interest rate, these differences in adaptation of interest rates can
cause an adverse impact on financial flows and the value of the bank.
3. Yield curve risk, which arises when changes in the values, slope and shape of the yield
curve have an adverse impact on the financial flows and value of the bank.
4. Optionality, or the existence of inserted options in the assets, liabilities and off-balance
sheet instruments. The risk lies in the fact that through the use of inserted options the
expected financial flows from financial instruments change, which subsequently has an
impact on the size of the interest-rate risk
MEASURING AND MANAGING RISKS

Methods of Measuring Interest Rate Risk

1. Maturity and Re-Pricing Tables – Gap Analysis This method is founded on the
classification of interest-rate sensitive assets, liabilities and off-balance-sheet items into
time bands defined in advance according to their maturity (in the case of fixed interest
rates), or time remaining until the next re-pricing (in the case of variable interest rates).
Through the difference between assets and liabilities in the individual time bands we
discover the size of the gap positions (periodic gaps). Summing up the periodic gaps
for a certain period, we get the cumulative gap for the given period. Through
subsequently multiplying the cumulative position by the forecast change in the interest
rate it is possible to ascertain the likely impact on interest financial flows.
MEASURING AND MANAGING RISKS
2. Duration In managing interest-rate risk the duration gap method is often
used, which is based on the duration of balance sheet items. In determining the
model for calculating the duration we work from a calculation of the net value
of an instrument with n financial flows2. The price of the instrument is given by
a function, which depends on the interest rate.
3.Price Value of a Basis Point This method is based on calculating the present
value of an instrument in the case of a certain market interest rate and
comparing this value with the present value of the same instrument, but
calculated for a different interest rate. The difference between the present
values for the different interest rates represents a change in the value in the
case of interest rate movements and is indicative of the sensitivity of the
instrument’s price to a change in the interest rate.
MEASURING AND MANAGING RISKS
4. Simulation Methods A further group of techniques comprises simulation
methods. These methods are founded on evaluating the potential simulated
impacts of interest rates on the simulated development of assets, liabilities
and off-balance-sheet liabilities. In the case of static simulations this is only a
simulation of the development of interest rates, whereas in the case of
dynamic simulations a bank simulates the development of interest rates and
the development of individual balance-sheet and off-balance-sheet items. In
the simulations there are most frequently used historical simulations, Monte
Carlo simulations or the bootstrapping method
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