INTEREST RATES

Introduction

So far it has generally been assumed that the interest rate 𝑖 or force of interest 𝛿 earned on an investment
are independent of the term of that investment.

In practice the interest rate offered on investments does usually vary according to the term of the
investment. It is often important to take this variation into consideration.

In investigating this variation, we make use of unit zero coupon bond prices. A unit zero coupon bond of
term 𝑛, say, is an agreement to pay 1/= at the end of 𝑛 years. No coupon payments are paid. It is also
called a pure discount bond.

We denote the price at issue of a unit zero coupon bond maturing in 𝑛 years by 𝑃𝑛 .

Spot Rates

The yield on a unit zero coupon bond with term 𝑛 years, 𝑦𝑛 , is called the “n-year spot rate of interest”.
And we have;
1
𝑃𝑛 =
(1 + 𝑦𝑛 )𝑛

The corresponding force of interest, defined as the n-year spot force of interest 𝑌𝑛 is given by:

𝑃𝑛 = 𝑒𝑥𝑝−𝑛𝑌𝑛
Illustration

The prices for zero coupon bonds of various terms are as follows:

1 year = 0.94 5 years = 0.70 10 years = 0.47 15 years = 0.30

Calculate the spot rates of interest for these terms and sketch a graph of these rates as a function of the
term.

Solution

The spot rates for the various terms can be found from the equations of value:
1 1 1
𝑃1 = 1
=> 𝑦1 = − 1 = − 1 = 6.4%
(1 + 𝑦1 ) 𝑃1 0.94
1 1
1 1 5 1 5
𝑃5 = 5
=> 𝑦5 = ( ) − 1 = ( ) − 1 = 7.4%
(1 + 𝑦5 ) 𝑃5 0.70
1 1
1 1 10 1 10
𝑃10 = 10
=> 𝑦10 = ( ) − 1 = ( ) − 1 = 7.8%
(1 + 𝑦10 ) 𝑃10 0.47
1 1
1 1 15 1 15
𝑃15 = 15
=> 𝑦15 = ( ) − 1 = ( ) − 1 = 8.4%
(1 + 𝑦15 ) 𝑃15 0.30
Since rates of interest differ according to the term of the investment, in general 𝑦𝑠 ≠ 𝑦𝑡 for 𝑠 ≠ 𝑡. Every
fixed-interest investment may be regarded as a combination of (perhaps notional) zero coupon bonds.
For example, a bond paying coupons of 𝐷 every year for 𝑛 years, with a final redemption payment of 𝑅 at
time 𝑛 may be regarded as a combined investment of 𝑛 zero coupon bonds with maturity value 𝐷, with
terms of 1 year, 2 years ..., n years, plus a zero coupon bond of nominal value 𝑅 with term n years.

Defining 𝑣𝑦𝑡 = (1 + 𝑦𝑡 )−𝑡 , the price of the bond is:

𝑃𝑟𝑖𝑐𝑒 = 𝐷(𝑣𝑦1 + 𝑣 2 𝑦2 + ⋯ + 𝑣 𝑛 𝑦𝑛 ) + 𝑅𝑣 𝑛 𝑦𝑛

The variation by term of interest rates is often referred to as the term structure of interest rates. The
curve of spot rates {𝑦𝑡 } is an example of a yield curve.

Illustration

Calculate the price of a five-year fixed-interest security on 100/= nominal, redeemable at par, with 6%
annual coupons if the annual term structure of interest rates is:

(7%, 7¼%, 7½%, 7¾%, 8%, …)

Solution

The price per 100 nominal is given by the equation:

𝑃𝑟𝑖𝑐𝑒 = 6(𝑣7% + 𝑣 2 7.25% + 𝑣 3 7.5% + 𝑣 4 7.75% + 𝑣 5 8% ) + 100𝑣 5 8% = 92.25

Why interest rates vary over time

The prevailing interest rates in investment markets usually vary depending on the time span of the
investments to which they relate. This variation determines the term structure of the interest rates.

The variation arises because the interest rates that lenders expect to receive and borrowers are prepared
to pay are influenced by the following factors which are not normally constant over time:

 Supply and demand: If cheap finance is easy to obtain or if there is little demand for finance (less
borrowers in the market compared to lenders), this will push interest rates down.
 Base rates: In many countries there is a central bank that sets a base rate of interest which
provides a reference point for other interest rates.
 Interest rates in other countries: The interest rates in a particular country will also be influenced
by the cost of borrowing in other countries because major investment institutions have the
alternative of borrowing from abroad.
 Expected future inflation: Lenders will expect the interest rates they obtain to outstrip inflation.
So periods of high inflation tend to be associated with high interest rates.
 Tax rates: If tax rates are high, interest rates may also be high, because investors will require a
certain level of return after tax.
 Risk associated with changes in interest rates: In general, rates of interest tend to increase as the
term increases because the risk of loss due to a change in interest rates is greater for longer-term
investments.
Common yield curves

Some examples of typical (spot rate) yield curves are given below.

Decreasing yield curve;

Since price is a decreasing function of yield, an

interpretation is that long-term bonds are more
expensive than short-term bonds.

There are several possible explanations – for

In this curve, the long-term bond yields are lower
than the short-term bonds.
example it is possible that investors believe that
they will get a higher overall return from long-
term bonds, despite the lower current yields,
and the higher demand for long-term bonds has
pushed up the price, which is equivalent to
pushing down the yield, compared with short-
term bonds.

Increasing yield curve;

In this curve the long-term bonds are higher

yielding (or cheaper) than the short-term bonds

Humped yield curve

In this curve the short-term bonds are generally

cheaper than the long bonds, but the very short
rates (with terms less than 1 year) are lower than
the 1-year rates.
Theories of the term structure of interest rates

The three most popular explanations for the fact that interest rates vary according to the term of the
investment are:

1. Expectations Theory

2. Liquidity Preference

3. Market Segmentation

Expectations Theory

The relative attraction of short and longer-term investments will vary according to expectations of future
movements in interest rates. An expectation of a fall in interest rates will make short-term investments
less attractive and longer-term investments more attractive. In these circumstances yields on short-term
investments will rise and yields on long-term investments will fall. An expectation of a rise in interest rates
will have the converse effect.

In the decreasing yield curve, it appears that the demand for long-term bonds may be greater than for
short, implying an expectation that interest rates will fall. By buying long-term bonds investors can
continue getting higher rates after a future fall in interest rates, for the duration of the long bond.

In the increasing yield curve, the demand is higher for short-term bonds – perhaps indicating an
expectation of a rise in interest rates.

Liquidity Preference

Short term bonds are viewed as being more liquid than long dated bonds. It is assumed that investors
prefer more liquid (short term) bonds, compared to less liquid (long-term) bonds. Longer dated bonds
therefore tend to be more sensitive to interest rate movements than short-dated bonds. It is assumed
that risk averse investors will require compensation (in the form of higher yields) for the greater risk of
loss on longer bonds. This might explain some of the excess return offered on long-term bonds over short-
term bonds in the increasing yield curve.

Market segmentation

Bonds of different terms are attractive to different investors, who will choose assets that are similar in
term to their liabilities. The liabilities of banks, for example, are very short term (investors may withdraw
a large proportion of the funds at very short notice); hence banks invest in very short-term bonds. Many
pension funds have liabilities that are very long term, so pension funds are more interested in the longest
dated bonds. The demand for bonds will therefore differ for different terms.

The supply of bonds will also vary by term, as governments, and companies’ strategies may not
correspond to the investors’ requirements. Remember that governments and companies issue bonds
because they need to borrow money, not because they are kind hearted and want to give investors
something to invest in. More bonds will be supplied if more money needs to be borrowed. This will put
downward pressure on prices.

The market segmentation hypothesis argues that the term structure emerges from these different forces
of supply and demand.

Measuring effect of change in interest rates on investments

One of the key factors a manager responsible for the investment of a fixed interest portfolio will be
concerned about is how the portfolio would be affected if there was a change in interest rates and, in
particular, whether such a movement might compromise the ability of the fund to meet its liabilities.

Interest rate risk

Suppose an institution holds assets of value 𝑉𝐴 , to meet liabilities of value 𝑉𝐿 . Since both 𝑉𝐴 and 𝑉𝐿
represent the discounted value of future cashflows, both are sensitive to the rate of interest. We assume
that the institution is healthy at time 0 so that currently 𝑉𝐴 ≥ 𝑉𝐿 .

If 𝑉𝐴 > 𝑉𝐿 , then we say that there is a surplus in the fund which is equal to 𝑉𝐴 − 𝑉𝐿 . If 𝑉𝐴 < 𝑉𝐿 then the
fund is in deficit.

If rates of interest fall, both 𝑉𝐴 and 𝑉𝐿 will increase. If rates of interest rise, then both will decrease. We are
concerned with the risk that following a downward movement in interest rates the value of assets
increases by less than the value of liabilities, or that, following an upward movement in interest rates the
value of assets decreases by more than the value of the liabilities.

In other words; for a fund currently in surplus we are concerned that after a movement in interest rates
the fund moves into deficit.

Immunization

Suppose an organization has liabilities that will require a known series of cash-flows (which we will assume
are all negative) and holds assets that will generate a known series of cash-flows (which we will assume
are all positive) to meet these liabilities.

If it were possible to select a portfolio of assets that generated cash-flows that exactly matched the
liabilities of the fund (in terms of timing and amount), then the fund would be completely protected
against any changes in interest rates. However, this is an idealized scenario and, apart from in very simple
cases, perfect matching of this kind cannot be achieved.

It may, however, be possible to choose an asset portfolio that offers the fund a milder form of protection.
Suppose the present value of the fund’s liabilities and assets, calculated at a valuation rate of interest 𝑖
which reflects the interest rate in the market, are 𝑉𝐿 (𝑖) and 𝑉𝐴 (𝑖). Then the fund would consider that it
has a surplus of 𝑉𝐴 (𝑖) − 𝑉𝐿 (𝑖). We can then consider how this surplus would be affected by changes in
the interest rate 𝑖. In particular, we will be concerned about the downside risk if a change in market
interest rates causes the surplus to become negative i.e. a deficit.

In simple cases it is possible to select an asset portfolio that will protect this surplus against small changes
in the interest rate. This is known as immunization. In the 1950s the actuary Frank Redington derived
three conditions that are required to achieve immunization.
The conditions for Redington’s immunization may be summarized as follows:

1. 𝑉𝐴 (𝑖) = 𝑉𝐿 (𝑖) – that is, the present value of the assets at the starting rate of interest is equal to
the value of the liabilities.
Where the present value of a cash-flow series is defined by;
𝑛

𝑉(𝑖) = ∑ 𝐶𝑡𝑘 𝑣 𝑡𝑘
𝑘=1
1
For a cash-flow series {𝐶𝑡𝑘 } from time 𝑡1 to 𝑡𝑛 and 𝑣 =
1+𝑖

2. The volatilities of the asset and liability cash-flow series are equal, that is; 𝑣𝐴 (𝑖) = 𝑣𝐿 (𝑖).
Where the volatility of a cash-flow series is defined by;

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 𝑣 𝑡𝑘 +1
𝑣(𝑖) =
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘

1
For a cash-flow series {𝐶𝑡𝑘 } from time 𝑡1 to 𝑡𝑛 and 𝑣 =
1+𝑖

3. The convexity of the asset cash-flow series is greater than the convexity of the liability cash-flow
series – that is, 𝑐𝐴 (𝑖) > 𝑐𝐿 (𝑖).
Where the convexity of a cash-flow series is defined by;

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 (𝑡𝑘 + 1)𝑣 𝑡𝑘 +2

𝑐(𝑖) =
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘

1
For a cash-flow series {𝐶𝑡𝑘 } from time 𝑡1 to 𝑡𝑛 and 𝑣 = 1+𝑖

We note that, if the first Redington’s condition holds, then for condition 2, it means we are simply
comparing the summation ∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 𝑣 𝑡𝑘 of the assets and liabilities. And similarly, for condition 3, we
are comparing the summation ∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 (𝑡𝑘 + 1)𝑣 𝑡𝑘 +2 .
Illustration

A fund must make payments of £50,000 at the end of the sixth and eighth years. Assuming that the
interest rate is 7% for all periods (terms), determine the volatility and the convexity of this fund.

Solution

For volatility;

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 𝑣 𝑡𝑘+1 50000(6)𝑣 7 + 50000(8)𝑣 9

𝑣(𝑖) = = = 6.5
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘 50000𝑣 6 + 50000𝑣 8

For convexity;

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 (𝑡𝑘 + 1)𝑣 𝑡𝑘 +2 50000(6)(7)𝑣 8 + 50000(8)(9)𝑣 10

𝑐(𝑖) = = = 48.9
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘 50000𝑣 6 + 50000𝑣 8

Illustration

Assume the fund in the above example has chosen to invest in two assets; a 5-year zero-coupon bond
paying 53,710/= at maturity and a 10-year zero-coupon bond paying 47,454/= at maturity. Is this fund
immunized against small changes in interest rates.

Solution

For condition 1, present value of assets must be equal to present value of liabilities, i.e.;
𝑛

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = ∑ 𝐶𝑡𝑘 𝑣 𝑡𝑘 = 50000𝑣 6 + 50000𝑣 8 = 62418

𝑘=1
𝑛

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 = ∑ 𝐶𝑡𝑘 𝑣 𝑡𝑘 = 53710𝑣 5 + 47454𝑣 10 = 62418

𝑘=1

For condition 2, volatility of assets must be equal to volatility of liabilities, i.e.;

𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 6.5

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 𝑣 𝑡𝑘 +1 53710(5)𝑣 6 + 47454(10)𝑣 11
𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 = = = 6.5
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘 53710𝑣 5 + 47454𝑣 10

For condition 3, convexity of assets must be greater than the convexity of liabilities, i.e.;

𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 𝑜𝑓 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 48.9

∑𝑛𝑘=1 𝐶𝑡𝑘 𝑡𝑘 (𝑡𝑘 + 1)𝑣 𝑡𝑘+2 53710(5)(6)𝑣 7 + 47454(10)(11)𝑣 12
𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 = = = 53.2
∑𝑛𝑘=1 𝐶𝑡𝑘 𝑣 𝑡𝑘 53710𝑣 5 + 47454𝑣 10

Therefore since 𝑐𝐴 (𝑖) > 𝑐𝐿 (𝑖), the fund is immunized against small changes in interest rates.