Fixed Income and Credit Risk

Prof. Michael Rockinger

B - 1 - Forward Products:
Foundations

1 / 21
Learning Objectives

Forward Products - Foundations

Notations and Definitions

Examples

Term structure of forward rates

Instantaneous forward rates

2 / 21
Need for Forward products
firm wishes to lend/borrow forward

t=0 T1 T2 Time
-

bank can manufacture forward lending/borrowing

-

To go further assume that one has bootstrapped from existing bonds a term
structure of discount factors Z(t, T) for all T.
This is, up to inversion, equivalent of having a term structure of rn (t, T) or
r(t, T)

3 / 21
Notations for forward rates and discount factors (PV156)
F(t, T1 , T2 ) — the T1 -value of 1 currency unit at T2

fn (t, T1 , T2 ) — annualized n-times compounded

forward rate associated with F(t, T1 , T2 )

f (t, T1 , T2 ) — continuously-compounded forward rate

limn!1 fn (t, T1 , T2 )
F(t, T1 , T2 ) is a discount factor to discount from T2 to T1 known at t
Proposition
Z(t, T1 ) ⇥ F(t, T1 , T2 ) = Z(t, T2 )
! n⇥(T2 T1 )
fn (t, T1 , T2 )
F(t, T1 , T2 ) = 1 +
n

Lemma
f (t,T1 ,T2 )⇥(T2 T1 )
F(t, T1 , T2 ) = e
4 / 21
 --
t

Notations for forward rates

F(t, 5,T2) discount
and discount factors (PV156)
faward factor att of
F(t, T1 , T2 ) — the Tunit
1 -value of 1 currency unit at T2
gettingI as i2we when
ave
fn (t, T1 , T2 ) to
— annualized
in
n-times compounded
forward rate associated with F(t, T1 , T2 )
F(t, 5, Tz) (1 i,t)) n/tz +) forward
-
-

compounded
f (t, T1 , T2 ) — continuously-compounded forward rate
n-
-

ate

limn!1 fn (t, T1 , T2 )
I

F(t, T1 , T2 ) is a discount factor to discount from T2 to T1 known at t

-

Proposition

No aubitrage angement:
zlt)
Z(t, T1 ) ⇥ F(t, T1 , T2 ) = Z(t, T2 )
I
-

I
a
lang farm investment

! n⇥(T
.

T1 )
f (t, T , T ) T2 2 routes
F(t, T1 , T2 ) --
n 1,i) 2 short
term interest
=- 1+ "ralled over"
21t, T) n forward
rate

Lemma
claim:Itmustbe that both rave
interest have the same value

f (t,T1 ,T2 )⇥(T2 T1 )

F(t,
ZIt,
=> T1 , T2 )Tel
= eZIt,
=

Tel. F(t, 5, tz)

4 / 21
An
abitrage I
in tums ofdiscountfactor
Notations
F(t,5,tz)
=>
En
for forward rates and"forward
=
discount factors
"Long"
of f"= DF (PV156)
F(t, T1 , T2 ) — the T1 -value of 1 currency unit at"Short"
T2 DF

fn (t, T1 , T2 ) — annualized n-times compounded ⑦

forward rate associated with F(t, T1 , T2 )

f (t, T1 , T2 ) — continuously-compounded forward rate

limn!1 fn (t, T1 , T2 )
F(t, T1 , T2 ) is a discount factor to discount from T2 to T1 known at t
Proposition
Z(t, T1 ) ⇥ F(t, T1 , T2 ) = Z(t, T2 )
! n⇥(T2 T1 )
fn (t, T1 , T2 )
F(t, T1 , T2 ) = 1 +
n

Lemma
f (t,T1 ,T2 )⇥(T2 T1 )
F(t, T1 , T2 ) = e
4 / 21
Remark

We will generally assume equally spaced payment dates. Ti = Ti 1 + . In

one year there are n time units , so that = 1/n

The forward discount factor for a time increment is:

n⇥ 1n
F(t, T, T + ) = (1 + fn (t, T1 , T2 ))
1
=
1 + fn (t, T1 , T2 )

5 / 21
Remark

The relation
Z(t, T1 ) ⇥ F(t, T1 , T2 ) = Z(t, T2 )
is a bit more than a definition.

One can show that under assumptions of liquidity, non-default of the

economy, stability of banks etc (I am not joking) this relation must hold as a
non-arbitrage relation!

During the GFC of 2007, this relation failed to hold

6 / 21
Moving cash across time

Z( t, T2 ) and r(t, T2 )
-

Z(t, T1 ) and r(t, T1 )

-
t=0 T1 T2 Time
-

-
F(t, T1 , T2 ) and f (t, T1 , T2 )

If one has Z(t, T) this is equivalent to having one of the spot interest rates
r(t, T)

7 / 21
Forward rate product: example (PV154)
Example
Today is April 28, 2020. A firm sells a piece of equipment to a client for $100 mln.
The client will pay in six months, on T1 = October 28, 2020.
The firm will need cash one year later, at T2 = April 28, 2021, to fund some
capital investment.
The firm would like to fix today the interest rate on the deposit of $100 mln
for the six month period from T1 to T2 .
The bank quotes the rate 4.21% and commits to pay $102.105 mln at T2 .
On April 28, 2020 (today), the value of the 6-months T-bill is $97.728 and the
value of the 1-year T-bill is $95.713. Assume that the nominal of T-bills is
$100.

How does the bank replicate such forward commitment by trading T-bills
today? Explain where the forward rate of 4.21% comes from.

8 / 21
 100 million
Beceive
↓

Forward
9 rate product: example
T T2
II
(PV154)
Gm 6m
Example
09,95 need cash interest
Today is April 28, 2020. A firm sells a piece of equipment to a client for $100 mln.
e
↓

The client will pay in six months, on T1 = October 28, 2020.

↓)outflow
The firm will need cash one year later, at T2 = April 28, 2021, to fund some
capital investment.
manufacturesthe forward
How The
can firm would like to fix today
bankmanufacture a riskless
strategy?
the interest rate on thecontract
->
deposit of $100 mln
for the six month period from T1 to T2 .
Bank
The bank quotes the rate 4.21%credit and commits to pay $102.105 mln at T2 .
= 100 millions
reimbursea
with 100m
On April 28, 2020
value of the 1-year
.
↓
(today), the value of the
100.210,6m) 6-months
100. 210,6m)T-bill is $97.728 and the 1
T-bill is $95.713. Assume that the nominal of F/t,
100.
=

isTz)
T-billsT,
-

I 10,12m)
$100. ↓ 12
= you ge from
place long term
In te
T2.
How does the bank replicate such forward commitment by trading T-bills
today? Explain where the forward rate of 4.21% comes from.

8 / 21
Make a Figure how to move cash

Bank places long-term

-

Bank borrows short-term

t=0 T1 T2 Time
-

Bank borrows forward

At T1 bank gets money from firm as firm receives its accounts receivables

9 / 21
Forward rate product: example (continued)

The bank borrows 1 mln units of T-bills with maturity T1 = 6 months today
and sells them for $97.728 mln. Cash is then invested in 1-year T-bills
expiring at T2 . Given that the price of the latter is $95.713, the bank can now
purchase $97.728/$95.713 = 1.02105 mln of 1-year T-bills (with a total
nominal of $102.105 mln).
Today, net cash flow is zero, as cash obtained from the sale of the 6 months
T-bills has been used to purchase 1 year T-bills.
In 6 months, the bank must pay back $100 million to the counterparty it
borrowed the 6 months T-bills from. This is also the time when the firm will
give the bank $100 million. So, at T1 the net cash flow is zero, as the bank
receives $100 million from the firm and uses it to close the short position.
At T2 , 1.02105 mln of 1-year T-bills mature, the bank receives $102.105
million. It pays the firm this entire amount.
In reality, banks charges a commission.

10 / 21
 141
Replicating forward rate FORWARD RATES AND FORWARD DISCOUNT FACTORS

Table 5.1 Trading Strategy to Compute Forward Rate

Today (Time 0) T1 T2

(a) Receive $100 m

Sell short $97.728 m of T-bills
from firm
maturing at T1
(b) Close short position

Buy M = 1.02105 = $97.728

$95.713
(a) Receive 1.02105 $100 m
of T-bills maturing at T2 (b) Give total to firm
Total Net Cash Flow = 0 Total Net Cash Flow = 0 Total Net Cash Flow = 0

The T
question is: How does the bank determine the forward rate f 2 ? 95.713
The 1 value of $1 at T2 , as viewed from today, is $0.979 = 97.728 .
The replication
⇣ implies ⌘ a forward interest rate on the deposit that
By no arbitrage.
102.105In fact, on March 1, 2001 (today), the value of 6-months
equals 2 ⇥ 100 1 = 0.0421 = 4.21%.
Treasury bills is $97.728 and the value of 1-year Treasury bills is $95.713. In order
to guarantee the rate f2 to the client, the bank can perform the following strategy (see
11 / 21
Bank lends forward

Bank borrows long-term

Bank places short-term

-
t=0 T1 T2 Time
-

-
Bank places forward

In this example, bank goes into financial markets and synthesizes a forward
lending position

12 / 21
Term structure of forward rates t t m
+
I

- I I

t m A
T
+ +

T2

The term structure of forward rates measured at time t is

f (t, t + m, t + m + ) as a one-dimensional function of m (the investment
horizon is held fixed). We often set t = 0 and plot f (0, T, T + ) as a
function of T . The result is called a forward curve. There are as many
forward curves as there are different horizons .

Market lingo: a continuously-compounded 2-year rate 1-year forward, i.e.,

f (0, 1, 3), is called by fixed-income traders a ‘1y2y rate’. ‘2y forwards’ would
mean a forward curve of 2-year rates, i.e., {f (0, T, T + 2)}T2T1 ,T2 ,...,TN .

With both m and varying, you get a matrix of forward rates: an up-to-date
version of such object every fixed income trader and quant have at most one
click away at any time. Once you have got a discount curve, you can
easily calculate forward rates for any m and .

13 / 21
 Ajouter
Spot and forward term structure: example
US Spot and 2y forwards curves as of Mar 2020
Spot curve
2y forwards curve
2.0

1.5
Interest rate, %

1.0

0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

14 / 21
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ee" R
firferm 00 ·Riskisksterfentiumsis istlattat(latz/is is
rembouse
De ↓Firsummerdedte tohedgedgethisthiswiskisk

to
Spot and forward term structure: example remre

↓ Ninterest both
hedge for
enter
feward with another bank
(hetetelstel

attentantensu
a

tant
->
=

US Spot and 2y forwards curves as of Mar 2020

Bankwill
ben Spot curve
->
implement a
duplicating strategy
2y forwards curve
2.0
NF(0,5,T2)
=

1.5 whyhy firfisms dodon't dodotiton on thatharawawn?

Interest rate, %

1.
Knowledge
2. No access the required markets
to

1.0
Justifics then the existance
of financial intermediation
te banks the
scans
of collateral
fer
risks the below -

Fae à ne
came
0.5 e

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

14 / 21
 210, Tel
E-ft)) -nIT2-5)
F10,5,52)
Spot fairand10,5,forward term structure: example
=

210,52)
in futures market
(F10,5,52) nir-n] -toward
rate quote someone
theoretical =>fn )
-

n.
=

faward late
90, 5,52)
R
8 in
US Spot and 2y forwards curves as of Mar 2020
I
Spot curve I time
2y forwards curve
fr=9n -> no
aubitrage possible tobig

g
2.0
forward
·
if th 39n- to lead
w
you want trader
to who

>
I I 3
1.5
sil
Interest rate, %

place
yallow LT

1.0 ·
if In 9 - to
want beartawaumtrade who quotes Sn-is
tu small

I, baaw credit tr
place linvest5
0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

14 / 21
 Spot and forward term structure: example
US Spot and 2y forwards curves as of Mar 2020
forward
Spot curve
2y forwards curve
M aureyes
2.0

1.5
Interest rate, %

1.0

0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

14 / 21
Relation between spot and forward curves (PV160/161)

Claim:
r(t, t + m + ) r(t, t + m)
f (t, t + m, t + m + ) = r(t, t + m) + (m + ) ,
ifspotame
i.e., when the spot curve is increasing, forward curve is above spot curve

Lf>r
Proof:
Z(t, T2 )
F(t, T1 , T2 ) =
Z(t, T1-dator
heldsdent
f (t,T1 ,T2 )(T2 T1 ) er(t,T1 )(T1 t)
e =
er(t,T2 )(T2 t)
f(t, 5, +z) ) r(t, T1 )(T1 t) r(t, T2 )(T2 t) =
= f (t, T1 , T2 )(T2 T1 )

Set T1 = t + m and T2 = t + m + . The rest is algebra.

15 / 21
Ajouter
Relation between spot and forward curves (PV160/161)

Claim:
r(t, t + m + ) r(t, t + m)
f (t, t + m, t + m + ) = r(t, t + m) + (m + ) ,

i.e., when the spot curve is increasing, forward curve is above spot curve

Proof:
Z(t, T2 )
F(t, T1 , T2 ) =
Z(t, T1
f (t,T1 ,T2 )(T2 T1 ) er(t,T1 )(T1 t)
e =
er(t,T2 )(T2 t)
) r(t, T1 )(T1 t) r(t, T2 )(T2 t) = f (t, T1 , T2 )(T2 T1 )

Set T1 = t + m and T2 = t + m + . The rest is algebra.

15 / 21
Relation between spot and forward curves (PV160/161)
Claim: For a set of dates {T1 , ..., Tn } such that Ti+1 = Ti + and T1 = we
have:
n
1 X "
⑧

r(0, Tn ) = f (0, Ti 1 , Ti ) ,
Tn i=1
i.e., the annualized continuously compounded interest rate r(0, T) is equal
to the average of forward rates up to T .

Proof: Establish relation for t = 0, T1 , T2 , T3 . Generalization is obvious.

By definition: f (0, T0 , T1 ) = r(0, T1 )

Z(0, T3 ) Z(0, T3 ) Z(0, T2 )

= = F(0, T1 , T2 ) ⇥ F(0, T2 , T3 )
Z(0, T1 ) Z(0, T2 ) Z(0, T1 )
e r(0,T3 ) T3
= e f (0,T1 ,T2 )(T2 T1 ) f (0,T2 ,T3 )(T3 T2 )
e r(0,T1 )T1
Set Ti Ti 1 = and conclude easily.

16 / 21
 o
I
2
-r(t,5)(is t) -

Relation between spot and g-rIt,ilin-t

forward curves (PV160/161)
e

!- FIt, T, Tz). F(t, T, T3)

=

=>

Claim: For a set of dates {T1 , ..., Tn } such that Ti+1 = Ti +-ft,,Tz).
and TD.
1 =
T2, 53). D
e-flt,we =

have: A Ti Ti
=
-

forward investmentfrom to toX

-

nty=telward investon from T, to in

1 and
r(0, Tn ) = f (0, Ti 1 , Tfrom
i) ,
in to
Ts
Tn i=1
ef,2,)
#.
T, D.

to the average of forward rates up to T . Back;itforwardStateet

i.e., the annualized continuously compounded interest rate r(0, T) is equal
a
ete
flt, ti, Ti) > r(t, Ti)

Proof: Establish relation for t = 0, T , T , T . Generalization isI obvious.

f(t, ,Tz)(t t) bitrage
+
-
-

2 ab
flt, ri, Ti < r(t, Ti)
(t, - +)(T t) 1 2 3
e
- -

By definition: f (0, T0 , T1 ) = r(0, T1 )

take en, change sign:r10,53)
=

(f(0,5) f(0,12) f(0,Te)) e

+
-

3
=

Z(0, T3 ) Z(0, T3 ) Z(0, T2 )

= = F(0, T1 , T2 ) ⇥ F(0, T2 , T3 )
r10,53)
Z(0, T1 ) Z(0, T 2 ) Z(0,
5 T1 ) ofI forward rate
=

e r(0,T3 ) T3
= e f (0,T1 ,T2 )(T2 T1 ) f (0,T2 ,T3 )(T3 T2 )
e r(0,T1 )TI
in =

Set Ti Ti 1 = and conclude easily.

16 / 21
Instantaneous forward rates

17 / 21
Instantaneous forward rate: Intuition

f (0,T,T+ )
We have by definition F(t, T, T + ) = e hence

1
f (0, T, T + ) = ln(F(t, T, T + )).

Z(t,T+ )
Since F(t, T, T + ) = Z(t,T) get that

ln(Z(t, T + )) ln(Z(t, T)
f (0, T, T + ) = .

If one takes the limit of converging to 0, one obtains the intuitive definition on
the following slide...

18 / 21
Instantaneous forward rate: Definition

The instantaneous forward rate is defined as:

F(t, T, T + )
f (t, T) = lim .
!0

It follows that
@
f (t, T) = ln Z(t, T).
@T

19 / 21
Instantaneous forward rate: Properties 1

Since
r(t, t + m + ) r(t, t + m)
f (t, t + m, t + m + ) = r(t, t + m) + (m + ) ,

Set T = t + m and T + = t + m + , trivially, as !0

@
f (t, T) = r(t, T) + (T t) r(t, T).
@T

20 / 21
Instantaneous forward rate: Properties 2

Remember:
n
1 X
r(0, Tn ) = f (0, Ti 1 , Ti ) ,
Tn i=1

Replace 0 by t, Tn by T , suppose Ti = Ti 1 + with Tn t=T t

Then, using directly the definition of Riemann integral, it follows that:

Z T
f (t, s)ds = r(t, T)(T t),
t

which is a very useful result for asset pricing.

if we can model
flt, i), we
then can recover the spot rate

21 / 21
Fixed Income and Credit Risk
Prof. Michael Rockinger

B - 2 - Forward Products
FRAs

1 / 12
Learning Objectives

Forward Rate Agreements (FRAs)

Definitions

Forward rate of an FRA

Value of a FRA at any time

Usefulness of a FRA: Example

2 / 12
Forward Rate Agreement (FRA) (PV162)
FRA is a non-cash contract (upon writing, no money is paid) between two
counterparties ageed upon at time t (today) such that: e

ol
One counterpart agrees to pay the forward rate fn (0, T1 , T2 ) on a given
notional amount N at the contract maturity T2 = T1 + . ↳o exe
This counterpart will receive at T2 a market floating rate rn (T1 , T2 ) that is not
observed until T1 .
② The other counterpart agrees to receive forward rate and to pay variable rate
The net payment for the counterpart who pays fixe and receives variable at
ISDA:I ntern.. Secuilies
maturity T2 is then given by: Deales Asso.

skewed contracts have been used

①: N (rn (T1 , T2 ) fn (0, T1 , T2 )) . in financial distress

Here, = T2 T1 is typically a quarter (0.25) or six months (0.5), while n = 1/

denotes the corresponding compounding frequency: n = 4 for quarterly and n = 2
for semi-annual periods. Opposite:skewed contract
differentfrom 4-value
Non-cash means that it costs nothing to enter a FRA at time t.
-

at t 0
=

3 / 12
 offuture
patis
~lat
L

Valuation of a FRA t
Retet
Spotrate
aholding
e

entime pate

end,
↓
At time T1 the rate r(T1 , T2 ) is known
-a
n

-
t=0 T1 rn/, +2) T2 Time
-
while down
centractbetween
a
6
-T2
T1 1
? reference
= +

2 counterpents amount

D = =
,p exchange
-Notional Amount

N
Here nothing happens at T1 all the CF payments take place at T2 reference qty

One counterpart receives a variable amount N r(T1 , T2 )

-

This counterpart pays a fixed amount N f (0, T1 , T2 )

>

In reality pays only the net amount (which can be negative) in which case it
receives

Namally the
"refrence"isthe fixed part ->
In 10,5, 527

4 / 12
 Question:Whatis the fair FRA- farward rates for T0, i, Tel A=

Valuation of a
the initial FRA
value of contracti s 4.

I
I
receive pay
The
payely atto
for fixed paye Atis:time T1linterest)
the
. rate r(T , T2 ) is known
NAun(in,T2) 1 NAfa* 10, t, Tel
en
-

invest
to
into
t-bill -
A
Value t = 00:
att
T1 NA***,0, T, tz) z10, Te) T2 Time
-
=

6
?
④

I
Tr
I
WhatIneed N ·

Here nothing happens at T1 all the CF payments take place at T2

-

have
to do to

I
N att ime in?
↳> One counterpart receives a variable amount N r(T1 , T2 )
InvestNEC0, Tel I

This counterpart pays a fixed amount N f (0, T1 , T2 )

in T-Bills
I

bank
borrowing from a I
In reality pays only the net-
amount
N
remain (which can be negative) in which case it
-

with
Nz(0, Tz) NAmst,i2)
receives
N(z(0,5)
z(0,52)]
=>
-

by def. (convention
↓
FRA:N(z10,5)
**

·Total value of -

z10, 52)] -NDf, 10, 5, T). z10, 52) 0

=

4 / 12
 =(**(0,5,52) z(0,71) z(0,52)-

A.z(0, Tz)
Valuation of a FRA
At time T1 the rate r(T1 , T2 ) 1is known

t=0
F10,5,Tz)
2
=

T 1
=

11 fn10, 5, 52)".
-
It)
T2
-

Time
AI =

-
+

-Tz -

6
=in 0,
+

i, il
?

Here nothing happens at T1 all the CF payments take place at T2

=
1
+
=>

n10,5,52)
One counterpart receives fn0,5,
a variable amount N r(T 1 , T2 ) tz) Eloate
+

=
=

This counterpart pays a fixed amount N f (0, T1 , T2 )

In reality pays only the net amount (which can be negative) in which case it
receives fn10, 5, T2) 1
=>

*10,5,52)
logic, otherwise
cubitrage opportunity
4 / 12
 N received
Application. ↓
Valuation of a FRA Tr
firm TR
⑧

I I
D n Tz
= = -
5

↑
At time T1 the rate r(T , T2 ) is known
N+1 interest ↓

-
wants to lockinto
a known rate between tn,
t=0 T1 T2 Time
Idea:ati n firm
-
is
going place
to a random rate, e.g. buying t-bills

frmtbenk wie
6
?

Baine:bank by contract, the firm veniable tate NBr(Tn, Ta)

firm
Here nothing happens at T1 all the CF payments place at T2
takepays
mule +
a when

the bank,
to and bank
the
pays fixed cate te the firm.

NAfr(0,5, Tz)N r(T1 , T2 )

One counterpart receives a variable amount
H FRA beak
pays fixed
which
in
firm
and receives fixed.
This counterpart pays a fixed amount N f (0, T1 , T2 )
NICE:Hae, end with
NB(ru(trital- netF
we
exchange
In reality pays only the net amount (which canfulo,
be negative)
Tall in which case it
an of
up
in,

Eculier:
receives
faward:firm paid bankatin, received N N= to atT2 Interest

-> amount under consideration ave much smallen =>isk!

Risk Creal lite) for banki s

going
to be offsetby similar
offsetting position -> NETTING

4 / 12
Hedging for banks:
Valuation of a FRA
Bunniecaste at

*
T2

T1
et
At time T1 the rate r(T
from1 firm2

receive in
*
bank

, T ) is known
low
gets
does

or
notc a e
the interestrate
if

high since it
is

-
T2
t=0 Time
Riski s thati n which
gets known atin
-
is
very
low
Ifr is
big)
6
?
ANfn10, T1, T2)

-
Here nothing happens
I atI T1 all the CF payments take place at T2
⑧
Ts Tz
One counterpart N a variable amount N
receives
NEC0, 51 r(T1 , T2 )
N(1 Arn)+,in))
+

This counterpart pays a fixed amount N f (0, T1 , T2 )

! /Nocisk
N w N. F-10, i, te)
-

In reality pays only the net amount (which can be negative) in which case it
receives

4 / 12
Valuation of a FRA: FRA Rate
At inception, FRA is worth 0
Payoff at T for paying fixed (like long position) is

N (rn (T1 , T2 ) fn (0, T1 , T2 )) .

The question is how can one ‘discount the math symbols’

N rn (T1 , T2 ).
can be generated by placing N into a deposit till T1 then reimburse a credit
that expires at T2 of N
Value at t = 0 of this is N(Z(0, T1 ) Z(0, T2 )).
Discounting N fn (0, T1 , T2 ) is trivial since this is a constant reimbursement
that needs to be made at T2
Total value at t = 0 is N(Z(0, T1 ) Z(0, T2 )) N fn (0, T1 , T2 )Z(0, T2 )

5 / 12
Valuation of a FRA: FRA Rate

At inception, FRA is worth 0

Total value at t = 0 is N(Z(0, T1 ) Z(0, T2 )) N fn (0, T1 , T2 )Z(0, T2 ) = 0
Hence
Z(0, T1 ) Z(0, T2 )
fn (0, T1 , T2 ) =
Z(0, T2 )
And we recover the formula for n-compounded forward rate:

Z(0, T1 )
1 + fn (0, T1 , T2 ) =
Z(0, T2 )

Rate on LHS, ratio of short over long on RHS

The FRA rate is the same as the forward rate!

6 / 12
 ↓+tz
Valuation of a FRA over time: t < T1
For t < T1 one discounts the terminal payoff as when one construct the value
at t = 0 of FRA rayoff ati2
generates the
This
at
- ained 8

V fra (t, T1 , T2 ) = N(Z(t, T1 ) Z(t, T2 )) N· · fn (0, T1 , T2 )Z(t, T2 )

I can we write this famille in a nicer
way? Payolf:
Since at t we have a new forward rate:
NA(rn(+, tz) tn10,5,T21)
-

Z(t, T1 ) Z(t, T2 )
fn (t, T1 , T2 ) =
Z(t, T2 )

One can substitute

above and obtain immediately the formula

Z(t, T1 ) Z(t, T2 )
/- tatlital

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · · (fn (t, T1 , T2 ) fn (0, T1 , T2 ))

Obtain value of FRA by replacing unknown future interest by forward

7 / 12
Valuation of a FRA over time: T1 < t < T2 in
I
T2

Payoff is known

ND(r(t,i2) -frCO, T, Tal]

In this case the interest rate rn (T1 , T2 ) is perfectly known

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · · (rn (T1 , T2 ) fn (0, T1 , T2 ))

8 / 12
Valuation of a FRA over time summary

Suppose three months after the inception of the contract (July 27, 2020) the
firm decides to close its FRA with the bank.

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · · (fn (t, T1 , T2 ) fn (0, T1 , T2 ))

For T1 < t < T2 we have:

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · · (rn (T1 , T2 ) fn (0, T1 , T2 ))

Knowing those values is useful for risk-management

9 / 12
FRA: Usefulness illustrated

Recall the firm with receivable of $100 million in six months on October 28, 2020
(T1 ). Today is April 28, 2020 (t). The firm wishes to invest this amount for
additional six months until April 28, 2021 (T2 ) at a predetermined rate. The firm
can enter into a six-month FRA with the bank for the period T1 to T2 , and notional
N = $100 million.
The bank agrees to pay at T2 the amount N · 0.5 · f2 (0, 0.5, 1), where
f2 (0, 0.5, 1) is the current semi-annually compounded forward rate for the
period T1 to T2 . The firm agrees to pay at T2 the amount N · 0.5 · r2 (0.5, 1),
where r2 (0.5, 1) is the semi-annually compounded spot interest rate as of T1 .
At T1 the firm receives $100 million and invests this amount at the market
interest rate r2 (0.5, 1).
The bank hedges the interest rate risk with T-Bills as before.

10 / 12
FRA: example (continued)
Net cash flow at T2 for the firm is:
!
Firm r2 (0.5, 1)
CF (T2 ) = N 1 + + N · 0.5 · (f2 (0, 0.5, 1) r2 (0.5, 1)) =
2
!
f2 (0, 0.5, 1)
=N 1+ = $102.105 million
2
Recall that the forward rate was: f2 (0, 0.5, 1) = 4.21%
The bank is now exposed to interest rate risk, as the FRA yields a negative
payoff if f2 (0, 0.5, 1) > r2 (0.5, 1). The bank hedges the interest rate risk with
T-Bills today (as before):

CF Bank (T2 ) = N · 0.5 · (f2 (0, 0.5, 1) r2 (0.5, 1)) + 1.02105 · N

!
r2 (0.5, 1)
N 1+ =0
2

11 / 12
 Hedge of a FRA (PV164)
150 INTEREST RATE DERIVATIVES: FORWARDS AND SWAPS

Table 5.3 Trading Strategy to Compute Forward Rate

Today (Time 0) T1 T2

(a) Borrow $100 m

Sell short $97.728 m of T-bills r2 (0.5,1)
at rate r2 (0.5, 1) Pay $100 m 1+ 2
maturing at T1
(b) Close short position

Buy M = 1.02105 = $97.728

$95.713 Receive 1.02105 $100 m
of T-bills maturing at T2

100 m
Enter FRA with Firm Pay 2
[f2 (0, 0.5, 1) r2 (0.5, 1)]
Total Net Cash Flow = 0 Total Net Cash Flow = 0 Total Net Cash Flow = 0

5.2.1 The Value of a Forward Rate Agreement

When two counterparties enter into a FRA, there is no exchange of money at the time of12 / 12
Fixed Income and Credit Risk
Prof. Michael Rockinger

B - 3 - Forward Products:
Forwards and Futures

1 / 18
Learning Objectives

Forwards and Futures

Definitions

No-arbitrage price of a Forward

Formula of a forward contract on a Bond

Futures Contracts

2 / 18
·Forward vs. futures:
Valuation
Forward: of between
OTCa FRA over time: T1 < t < T2
two counterpents

Futures:taded on
organized markets

CFC:Global Financial Gisis

I all toward and futures have

go a

eaparty
to to

Plattern
clearing
For both Fawards + Future then will be market to-mauket
In this case the interest rate rn (T1 , T2 ) is perfectly known
-

->
Callateralization

V fra (t, T1 , T2 ) = Z(t, T2 ) · N ·

0 · (rn (T1 , T2 )
T fn (0, T1 , T2 ))
acheloz:SpotmaketSy cows =

I I

Strat.
forward
I
1:enter contractwith
a
into
forward price oft o ->Pay to atT

/Strat. buy natalingartsde

2: cow new, casts to financed with modtthat back -
you pay
atT. So (1 +)T
Y sell the
So +Ho-Do fertene milk
=>
(So +Ho-Do) (1tr) Do

Dire te else
same result;costmustbe the
same, arbitrage Soltr)+
Fo=

↳ Fo =

(So Ho -bu)(1 r)+

+
+

cash-and-caly
8 / 12
Forward contracts
A non-cash contract is a contract (legally binding piece of paper) where at the
time of the writing, there is no exchange of money.

A forward contract is a non-cash contract between two counterparties agreed

upon today (time t = 0) about exchanging a given security at a predetermined
forward price Pfwd (0, T) at a given future date T

Forward price Pfwd (0, T) is a price for a delivery at T of a security that

matures at some later date

We denote by P(T) the (spot) value of the underlying security at the delivery
date T

The payoff at T of being long the forward contract is:

P(T) Pfwd (0, T)

Remark: Here we assume that the underlying has no CFs till T , else one needs
to remove them since the forward contract does not include the cash flows payed
before T
3 / 18
·How
getpar10, 5?
to

Forward
Strat contracts
getthe asset? 1). Enles
to
a fud contract
Pay pt40, i) atT.
A non-cash contract is a contract (legally binding piece of paper) where at the
·Buy
time of the writing, there is no
asotnow, hold until
exchange of money. it t.

Finance with aeditthat reimburse atI

you
A forward contract is a non-cash contract between
↓
two counterparties agreed
cost
Plo), creditzeimbursed at
upon today (time t = 0) about exchanging a given security at a predetermined
P(0) /0,i) 7: z
-

fwd
forward price P (0, T) at a given future date T
pfnd(0,5) P(0) z(0,5)
=>

Forward price Pfwd (0, T) is a price for a delivery at T of a security that

matures at some later date
2) "Discountthe math symbols"
We denote by P(T) the
Q
(spot) value of the underlying security at the delivery
whati s the value of
generating the
payoff
is
date T atT.

- Rayoff: (0, 5) ptud

The payoff at T of being long the forward contract is:
↓ ↓ Non-cash contract:initial
How generate?
BeatsP(T) Pfwd (0,53 T)
ptudio,
value mustbe zero
0,5)
-
-
P(0) -

Remark: Here we assume that the underlying has no CFs

P(0) pfy8,5z(0,5)
till T , else one needs -

0
=

to remove them since the forward contract does not include the
pfwd(0,T) cash flows payed
P(0)z)0,5) =>
=
-

before T
3 / 18
 Isat t:discountthe P(t)-pt*,0,57Z/, T)
Forward contracts symbals until t:

A non-cash contract is a contract (legally binding piece of paper) where at the

time of the writing, there is no exchange of money. pod P(t) z St, T)
=>

=
-1

A forward contract is a non-cash contract between two counterparties agreed

fwd
->
(p+9(t,1) p+4(0,+1]z/7,5)
upon today (time t = 0) about exchanging a given security at a predetermined
-

forward price P (0, T) at a given future date T

Forward price Pfwd (0, T) is a price for a delivery at T of a security that

matures at some later date

We denote by P(T) the (spot) value of the underlying security at the delivery
date T

The payoff at T of being long the forward contract is:

P(T) Pfwd (0, T)

Remark: Here we assume that the underlying has no CFs till T , else one needs
to remove them since the forward contract does not include the cash flows payed
before T
3 / 18
Forward contracts

Determination of the forward price of asset is obtained by considering strategies

with identical payoffs

One can get physically the bond which will be worth P(T) at time T by
purchasing the bond for a price P(0) at t = 0

One can also get the bond by paying a forward price of Pfwd (0, T) at T . At
t = 0 this is worth Z(0, T) · Pfwd (0, T)

Hence, in a non-arbitrage world, must be that

Z(0, T) · Pfwd (0, T) = P(0) ) Pfwd (0, T) = P(0) · Z(0, T) 1

4 / 18
Forward contracts
To establish the value of the contract at some later date, one needs to ask how
one could obtain the payoff
P(T) Pfwd (0, T)
by some duplicating trading strategy

At time t if one purchases the bond at market price P(t) one is certain to get
the value of the bond at time T worth P(T)

The discounted value of Pfwd (0, T) at t is Z(t, T) · Pfwd (0, T)

Hence, at t value is
P(t) Z(t, T) · Pfwd (0, T)

Since at t there is a new forward price Pfwd (t, T) = P(t) · Z(t, T) 1

one can
also write the value of the contract as:
⇣ ⌘
V(t, T) = Z(t, T) · Pfwd (t, T) Pfwd (0, T)

5 / 18
Valuation of a forward contract on a bond

t=0 T1 T2 Tm
- Time
6 ? ? ?
c · 100 c · 100 (1 + 2c ) · 100
P(0) 2 2

Contract matures at T : 0 < T < T1

c
Bond pays semi-annual coupon 2 · 100 at times Ti for i = 1, · · · , m. Maturity
of bond is at time Tm

Denote the set of all future payment dates by T = {T1 , · · · , Tm }

rewrite bond forward price as Pfwd (0, T, T)

6 / 18
Valuation of a forward contract on a bond
Must have that
c c
Pfwd (0, T, T) Z(0, T) = · 100 · Z(0, T1 ) + · · · + · 100 · Z(0, Tm ) + 100 · Z(0, Tm )
2 2

This implies that:

c Z(0, T1 ) c Z(0, Tm ) Z(0, Tm )

Pfwd (0, T, T) = · 100 · + · · · + · 100 · + 100 ·
2 Z(0, T) 2 Z(0, T) Z(0, T)

recognize in the ratios of df the forward price in interest rate

c c
Pfwd (0, T, T) = · 100 · F(0, T, T1 ) + · · · + · 100 · F(0, T, Tm ) + 100 · F(0, T, Tm )
2 2

Forward bond price is obtained by discounting the future cash flows from the
future payment dates to the maturity date of the forward

7 / 18
Valuation of an existing forward contract on a bond at
0<t<T

Suppose that 0 < t < T then

c c
Pfwd (t, T, T) Z(t, T) = · 100 · Z(t, T1 ) + · · · + · 100 · Z(t, Tm ) + 100 · Z(t, Tm )
2 2

8 / 18
Valuation of a forward contract on a bond at 0 < t < T

The value of the forward contract for every ⌧ s.t. 0 < t < T is equal to (results
from slide 5)
⇣ ⌘
V fwd (t, T) = Z(t, T) Pfwd
c (t, T, T) Pfwd
c (0, T, T) .

9 / 18
Futures contracts

Futures contracts, similarly to forward contracts, are contractual

agreements between two counterparties to deliver a certain security
or cash at maturity and for a predetermined price, called futures
price.

Yet, there are important differences:

Futures contracts are traded on a regulated exchange (e.g. CME),
which defines the characteristics of the contract, acts as counterparty
to investors, and guarantees that payments will be honored at maturity.

The security underlying the futures contract is standardized, there is

no room for customized requests from clients.

Profits and losses are marked-to-market daily, meaning that they

accrue over time to short and long traders with daily frequency.

10 / 18
Further Characteristics of Future Contracts
Market-to-market

Do not confuse mark-to-market with market-to-market

(same logic, different contexts)

Mark-to-market means that a bank values its assets (and liabilities)

and then registers their values in its books

Market-to-market is a technique to ensure, at a relatively small cost,

that both counterparts honour their contract

The M2M has become key for counterparty risk management in so called
CCPs (Central Counterparty Clearing House)

11 / 18
Market-to-Market
1 Both long and short parties establish margin accounts. For instance
70

2 If a margin account falls below 50 (for instance to 40) a margin call

gets issued. The counterpart must then fill its accounts back to 70. If
it does not, the counterpart is declared bankrupt

3 At maturity T , long party pays short party the spot price (current
market price)

4 Over time there are adjustments between the 2 accounts: the

market-to-market. These are compensation payments

Now you should be perfectly confused!

12 / 18
 I
Market-to-Market

Because of the assumption that at T , long pays spot to short it must

be that

Pfwd (T, T) = P(T)

To demonstrate this
1 assume that Pfwd (T, T) < P(T)...

2 assume that Pfwd (T, T) > P(T)...

13 / 18
Market-to-Market
Time to Short Position Futures Long Position
maturity Seller Price Pfwd (t, T) Buyer
8 70 170 70
7 70+10=80 160 70-10=60
6 80+20=100 140 60-20=40+30=70
5 100+20=120 120 70-20=50
4 130
3 140
2 120
T t !1 110
T !0 100

Exercise: fill matrix and verify that short receives from long overall
170 and that long pays to short overall 170
Exercise: when are there times of potential default? Why does default
not matter?
14 / 18
Market-to-Market

Time to Short Position Futures Long Position

maturity Seller Price Pfwd (t, T) Buyer
8 70 170 70
7 70+10=80 160 70-10=60
6 80+20=100 140 60-20=40+30=70
5 100+20=120 120 70-20=50
4 120-10=110 130 50+10=60
3 110-10=100 140 60+10=70
2 100+20=120 120 70-20=50
1 120+10=130 110 50-10=40+30=70
T !0 130+10=140 100 70-10=60

If no default, long pays 100 + 70 + 30 + 30 60 = 170

If no default, short receives 100 + 140 70 = 170

15 / 18
Discussion of Default Possibilities

Time to Short Position Futures Long Position

maturity Seller Price Pfwd (t, T) Buyer
6 80+20=100 140 60-20=40+30=70

1 120+10=130 110 50-10=40+30=70

0 130+10=140 100 70-10=60

First moment of possible default: margin call at t = 6. In that case,

short can enter a new contract with someone else. The new price
would be Pfwd (T t = 6) = 140. It would seem that short gets much
less than initially promised 170, but if one considers the margin
account, the account has risen to 100 from 70. 100 70 = 30!
Second moment of possible default: margin call at t = 1

16 / 18
Discussion of Default Possibilities

Time to Short Position Futures Long Position

maturity Seller Price Pfwd (t, T) Buyer
0 130+10=140 100 70-10=60

Default at T of long position.

If long defaults, short sells in spot market and receives 100. Since
margin account increased by 70, overall short receives 170

Default at T of short position

If short defaults, long can buy underlying in spot market for 100. Since
margin account decreased by 10 and because of margin payments of
60, overall long will pay 170

17 / 18
Pricing Futures and Forwards

Great news: If the interest rates are constant or do not vary a lot, then
the price of a future equals that of a forward

Intuition: If interest rates are constant then the remuneration of the

margin deposits will be the same be it a futures or a forward

18 / 18
Fixed Income and Credit Risk
Prof. Michael Rockinger

B - 4 - Floating Rate Notes

1/8
Learning Objectives

Be able to explain what a FRN is

Obtain the price of a FRN at reset dates

Obtain the price of a FRN at non-reset dates

2/8
Floating Rate Notes (PV521 )
Floating Rate Notes (FRN) nickname floaters are bond-type
financial instruments: there is a time varying coupon which gets
regularly rest. Bond may expire after many years.

Coupon depends on a reference rate, say rn (Ti 1 , Ti ) which will be

reset at time Ti 1 and paid at time Ti . The times Ti 1 are called reset
dates. Which leads to lingo such as: the interest rate has been
‘resetted’.

Assume Ti = Ti 1 + , thus, times are regularly spaced, = 1/n

Time runs from t = 0 via Ti for i = 1, · · · , m so that at time Tm the FRN

ends
1
There is a change of notation in Veronesi’s book which renders understanding more
complicated. Better stick to my stuff
3/8
Valuation of an FRN

At time Ti 1 the rate rn (Ti 1 , Ti ) is known

-

t=0 Ti 1 Ti Time
-

?
CTi = cTi · N

At time Ti the coupon rate will be cTi = · [rn (Ti 1 , Ti ) + s] where s is an

annualized spread.
A firm which is subject to default risk may wish to pay to its creditors a rate
which is above the (reference rn ) interbank rate. The spread s reflects this
compensation. 4/8
Floating Rate Notes: Pricing

Notice that the payments over time can be split into a variable part
and a constant-over-time part

At the payment date Ti the payment is

CTi = rn (Ti 1 , Ti ) N + sN

The value, at t = 0, of the constant part s N is trivial to obtain, it is an

annuity

Hence, let us focus on the variable part. How can we discount this
part?

5/8
Floating Rate Notes: Pricing of the variable part
The value of the variable part is found by starting from the end
(backward induction)
At the terminal payment date Tm the payment is

rn (Tm 1 , Tm ) N + N = [1 + rn (Tm 1 , Tm )] N.

At time Tm 1 the value of the variable part of the bond is

Z(Tm 1 , Tm )[1 + rn (Tm 1 , Tm )] N

But
1
Z(Tm 1 , Tm ) =
1 + rn (Tm 1 , Tm )
and so the value of the variable part at time Tm 1 is:
[1 + rn (Tm 1 , Tm )] N
= N.
1 + rn (Tm 1 , Tm )

6/8
Floating Rate Notes: Pricing of the whole thing at t = 0
One iterates happily backwards to obtain that at t = 0 the value of the
variable part is N

Put things together...

The value, at t = 0 of the fixed part is simply

m
X
s N Z(0, Ti )
i=1

And, so the total value of the FRN at t = 0 is simply:

m
X
N+ s N Z(0, Ti )
i=1

7/8
Floating Rate Notes: Pricing of the whole thing at t , 0
Suppose the FRN has already lived till time t with Ti 1 < t < Ti
The value, at t of the fixed part is simply
m
X
s N Z(t, Tj )
j=i

For the variable part, recognize that the spot interest rate between
Ti 1 and Ti has been set already
Hence, the value, at t of this part is
Z(t, Ti )[1 + rn (Ti 1 , Ti )] N

And, so the total value of the FRN at t is

m
X
Z(t, Ti )[1 + rn (Ti 1 , Ti )] N + s N Z(t, Tj )
j=i

8/8
Fixed Income and Credit Risk
Prof. Michael Rockinger

B - 5 - Interest Rate Swaps

1 / 19
Learning Objectives

Definition of an Interest Rate Swap (IRS)

Usefulness

Determining the Swap Rate, by discounting payoffs

Determining the Swap Rate, by decomposing payoffs

Bootstrap of discount curves from swap rates

2 / 19
Interest Rate Swap (PV171)
A vanilla fixed-for-floating interest rate swap is a contract between two
counterparties in which

One counterparty agrees to make n fixed payments per year at an

annualized swap rate c on a notional N up to a maturity date T , i.e., the
payment dates are T1 , T2 , . . . , Tm = T
As usual, Ti = Ti 1 + , = 1/n and assume i = 1, · · · , m

The other counterparty commits to make payments at the same dates linked
to a floating rate index rn (Ti 1 , Ti )

The net payoff for the counterparty which pays fixed at date Ti is:
N· · (rn (Ti 1 , Ti ) c)

What defines a counterparty is if it either pays fixed or receives fixed. Fixed

is the reference. Thus: a if you have a payer swap, it means you pay fixed
rate
3 / 19
Interest Rate Swaps, Payoffs

At time Ti payoff for a payer swap is therefore

N· · (rn (Ti 1 , Ti ) c)

For i = 1, · · · , m

T0 = 0 T1 T2 Tm
- Time

4 / 19
Interest Rate Swaps, Payoffs

In real life the contract comes alive at T0 delivery date whereas price
was set at t = 0 value date

Typically between t = 0 and T0 there will be 2 days. We will assume

T0 = 0 to make our algebra a tiny bit easier.

There exist mini forward contracts for those 2 days. Spot-next and
Tom-next

5 / 19
Interest Rate Swap: example (PV174)
A firm and bank decide to enter into a fixed for floating semi-annual 5-year swap

5.4 INTEREST RATE SWAPS

with swap rate c = 5.46% and notional amount N = $200 mln. The reference
floating rate is the 6-month LIBOR.

6 / 19
Interest Rate Swap: another example
A more realistic example. Today is April 28, 2023 and a firm sold a piece of
equipment to a highly rated corporation. The firm is due to receive payments in
10 equal semi-annual installments of $5.5 mln each over next 5 years.
The firm would like to use these $5.5 mln semi-annual cash flows to hedge against
the coupon payments needed to service a $200 mln floating rate bond that it issued
in the past, which is expiring in 5 years.
Suppose that the floating rate on the corporate bond is tied to the US LIBOR, at
LIBOR + 4bps.
The 6-month LIBOR on March 1, 2003 is at 4.95% and so the next interest rate
payment the firm must make is:
(4.95 + 0.04)%
⇥ $200 mln = $4.9 mln.
2

However, if the LIBOR were to increase by more than 0.51% in the next 5 years, the
cash flows from the installments would not be sufficient to service the debt.

7 / 19
Interest Rate Swap: another example (continued)

A solution is to enter into a fixed for floating swap with an investment bank, in
which the firm pays the fixed semiannual swap rate c, over a notional of $200
million, and the bank pays the 6-month LIBOR to the firm.
On April 28, 2023, the swap rate for a 5-year fixed-for-floating swap is quoted at
c = 5.46%.
In this case, the net cash flow to the firm from the swap contract is:

$200 mln · 0.5 · (r2 (Ti 1 , Ti ) 5.46%).

The firm’s net cash flow at Ti from the receivable, debt, and swap is:

$5.5 mln + $200 mln · 0.5 · (r2 (Ti 0.5, Ti ) 5.46%)

$200 mln · 0.5 · (r2 (Ti 0.5, Ti ) + 0.04%) = 0.

8 / 19
Interest Rate Swap example: illustration (PV174)

9 / 19
Determining the Swap Rate
There are two approaches to determine the swap rate.
In the first approach, one considers the individual payoffs and one
discounts those payoffs back to the initial date. This is something that
we have already done since each payoff can be viewed as a forward
rate agreement. Thus, it turns out that a swap is nothing but a
basket of FRAs.
In the second approach, one introduces a fictitious terminal payment
of the notional N from counterparty A to counterparty B and an
identical payment from counterparty B to counterparty A, and then
one recognizes that the fixed leg corresponds to a good’ol constant
coupon bond and the variable leg to a floating rate bond.
Once one has discounted the payoffs at the various dates, one sets
the initial value of the IRS to 0 and obtains the swap rate.
Both approaches yield the same expression for the swap rate: it is the
difference between the short discount factor and the long discount
factor, the whole divided by an annuity!
10 / 19
Determining the Swap Rate: Discounting Payoffs

How can one compute the present value of the payoff at time Ti

rn (Ti 1 , Ti ) N cN

Easy part: Discount c N which yields c N Z(0, Ti )

11 / 19
Determining the Swap Rate: Discounting Payoffs
How can one compute the present value of the payoff at time Ti

rn (Ti 1 , Ti ) N cN

To generate rn (Ti 1 , Ti ) N the insight is that this would be the

interest, and only that, if one had placed at time Ti 1 an amount N at
rate rn (Ti 1 , Ti )

If one places at time Ti 1 an amount N one gets at time Ti

(1 + rn (Ti 1 , Ti )) N

Thus by subtracting N at time Ti one remains with the interest

The ‘discounted value’ of rn (Ti 1 , Ti ) N is therefore

N · (Z(0, Ti 1 ) Z(0, Ti ))

12 / 19
Determining the Swap Rate: Discounting Payoffs
By considering all discounted payoffs and setting the swap rate so
that the swap has a zero value, we obtain the swap rate!

Value of swap is:

m
X m
X
V0 = c N Z(0, Ti ) N · [Z(0, Ti 1 ) Z(0, Ti )] = 0
i=1 i=1

Notice that
m
X
(Z(0, Ti 1 ) Z(0, Ti )) = Z(0, T0 ) Z(0, Tm ) = 1 Z(0, Tm )
i=1

Setting the initial value V0 of the swap equal to zero yields:

1 Z(0, Tm )
c= Pm
i=1 Z(0, Ti )

13 / 19
Interest Rate Swaps, Payoffs decomposed (approach 2)
Decompose the payments over the life of the swap into a floating and
a fixed payment. Also add a terminal payment of the notional amount
N (in red) which is just a trick so that both legs look like instruments
we know (FRN and bond)
recognize that with the trick A pays CF of a bond and receives CF of
an FRA

cN cN cN + N
Counterparty A ? ? ?

6 6 6
Counterparty B rn (T0 , T1 )N rn (Tm 1 , Tm )N + N
rn (T1 , T2 )N

T0 = 0 T1 T2 Tm
- Time

14 / 19
Interest Rate Swaps, Payoffs decomposed
Value at t = 0 of bond
m
X
Z(0, Ti ) c N + Z(0, Tm ) · N
i=1

Value at t = 0 of floater
N
Both legs must have same value, swap has an initial value of 0:
m
X
N= Z(0, Ti ) c N + Z(0, Tm ) · N
i=1

Simplify and get:

1 Z(0, Tm )
c= Pm
i=1 Z(0, Ti )

As promised, this is exactly what we were supposed to get before.

15 / 19
Value of Interest Rate Swaps after t = 0

Suppose Tj 1 < t < Tj for some j

Value at t of bond
m
X
Z(t, Ti ) c N + Z(t, Tm ) · N
i=j

Value at t of floater
Z(t, Tj )N(1 + rn (Tj 1 , Tj ))

Value of swap is:

m
X
V(c, t, Tj ) = Z(t, Tj )N(1 + rn (Tj 1 , Tj )) Z(t, Ti ) c N Z(t, Tm ) · N
i=j

Formula does not look nice, c’est la vie.

16 / 19
Bootstrapping the Swap Rate

In practice there is a large spectrum of swap rates cTi for many dates
Ti 2 {0.5, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 15, 20, 25, 30} years
Swaps are much many more liquid than bonds. So instead of using
bonds to bootstrap discount curves, use swap rates.

It is easy to estimate a curve running through all the dates (quarterly,

or semi annual) and estimate the parameters of such a curve via a
non-linear optimization program.

P. S. Hagan and G. West (2006). Interpolation Methods for Curve

Construction. Applied Mathematical Finance, Vol. 13, No. 2, 89-129,
June 2006

17 / 19
Bootstrap swap rates
Once you know the discount curve, you can uniquely determine the swap rate for
every maturity Tm of a swap contract:
0 1
BBB 1 Z(0, Tm ) CCC
cn (0, Tm ) = n @B Pm CA ,
j=1 Z(0, Tj )

where we denoted cn (0, Tm ) the swap rate, calculated at inception, for the contract
maturing at Tm with = 1/n.
The swap curve is the set of swap rates for all maturities {cn (0, Tm )}m as a
function of Tm .
Swaps are very liquid instruments. Hence, market swap rates are often
used to back out (bootstrap) the discount curve:
1
Z(0, T1 ) = ,
1 + cn (0, T1 )/n
P 1
1 (c(0, Tm )/n) · m j=1 Z(0, Tj )
Z(0, Tm ) = .
1 + cn (0, Tm )/n
This later formula can be used recursively, m = 1, m = 2, and so forth...
18 / 19
 Spot and swap curves: example
US spot and swap curves as of Mar 2020
Semi−annually compounded spot rate
Semi−annually compunded swap rate

2.5

2.0
Interest rate, %

1.5

1.0

0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

19 / 19