Interest Rates

1
Interest Rate Models
Yannick Malevergne
Professor of Finance
Institute of Business Administration (University Jean

Monnet)
& EMLYON Business School
Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

2
Valuing a Bond
• The simplest kind of bond is the Zero-

coupon bond (or discount bond):
– B(t,s): price, at time t, of a bond maturing at
time s≥t, with maturity value $1
It is the Present Value (at t) of 1$ received at s.

3
Valuing a Bond
• Zero-coupon bond (discount bond):
– B(t,s): price, at time t, of a bond maturing at time
s=t+T≥t, with maturity value $1
It is the Present Value (at t) of 1$ received at s=t+T.
• Its internal rate of return is the
Yield-to-Maturity:
1
R(t , T ) = [ln($1) − ln B(t , t + T )]
T
1
R(t , T ) = − ln B(t , t + T )
T
4
Terminology
• Zero-coupon bond (discount bond):
– B(t,s): price, at time t, of a bond maturing at time s≥t,
with maturity value $1
It is the Present Value (at t) of 1$ received at s.
• Yield-to-Maturity (Internal rate of return):
1
R(t , T ) = − ln B(t , t + T )
T
• The spot rate:
r (t ) = lim+ R(t , T ) = −∂ s ln B(t , s ) s =t
T →0

5
Valuing a Bond
• A bond pays a coupon Ci at each time ti from
now, i=1,…N and redeems the principal P at
time tN. What is the price of the bond?
• Value of a bond = Present value of its future

cash-flows
Yield-to-maturity (Internal Rate of Return)

6
Equivalence between continuous and discrete time discounting
N periods with rate R per period and r per unit time covering
a total time interval T
1 1   T 
= = exp  − N  + r 
ln 1
(1 + R ) 
N
T
N
  N 
1 + r 
 N
 T
≈ exp − r N  = exp(− rT )
 N

7
Impact of interest rates on bond price

• To induce people to save, r⇑ to increase future (1+r)n
value
n
Future V = (1+ r )
1
• If r⇑, present value of future fixed payments⇓

d d d F+ d
V= + + ...+ + Value of bond⇓
1+ y (1+ y)2
(1+ y) (1+ y)
n−1 n
1
1/(1+r)n
8
Debt & Interest Rates

Classical Theory of Interest Rates (Economics)
• developed by Irving Fisher
Nominal Interest Rate = The rate you actually

pay when you borrow money

9

Classical Theory of Interest Rates (Economics)
• developed by Irving Fisher
Nominal Interest Rate = The rate you actually pay when you
borrow money
Real Interest Rate = The theoretical rate you pay when you
borrow money, as determined by supply and demand
r
Supply
Real r
Demand
$ Qty
10

Nominal r = Real r + expected inflation
Real r is theoretically somewhat stable
Inflation is a large variable
Q: Why do we care?
A: This theory allows us to understand the Term Structure of
Interest Rates.
Q: So What?
A: The Term Structure tells us the cost of debt.

11
UK Bond Yields
14
12
10
Nominal Yield on UK 10 yr bonds
Percent
2 Real Yield on UK 10 yr bonds
0
janv-85
janv-86
janv-87
janv-88
janv-89
janv-90
janv-91
janv-92
janv-93
janv-94
janv-95
janv-96
janv-97
janv-98
janv-99
janv-00
janv-01
janv-02
janv-03
janv-04
12
Valuing a Bond
• A bond can be seen as a portfolio of zero-
coupon bonds

13
Valuing a Bond
• Payoff of the bond:
t1 t2 tN-1 tN
↓ ↓ ↓ ↓
C1 C2 … CN-1 CN+P
• Replication:
– Invest $ C1xB(t,t1) at t  Receive $C1 at t1
– Invest $ C2xB(t,t2) at t  Receive $C2 at t2
– Invest $ CN-1xB(t,tN-1) at t  Receive $CN-1 at tN-1

– Invest $ (P+CN)xB(t,tN) at t  Receive $(P+CN) at tN
Present value of the Payoff of the bond

replication portfolio

14
Valuing a Bond
• In the absence of arbitrage opportunity, the value of the
bond is equal to the value of its replication portfolio:
In the absence of arbitrage opportunity, the knowledge of the

price of all the zero-coupon bonds allows pricing any bond
• Term-structure: the sequence of bonds, yields, interest rates

at different times-to-maturity

15
Yield curve (Feb 2004)
Yield curve: Yield-to-Maturity vs. Maturity

5
4.5
4
3.5
3
Percent
2.5
2
1.5
1
0.5
0
Maturity Year
Nov 2014
Feb 2004

16
Yield curve: examples of 18 Jan 2007
• Germany
• UK
• USA

17
Spot/Forward rates
Imagine that Julie wants to invest $1 for two years.

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Spot/Forward rates
(1+r2)2 = (1+r1) (1+f2) but not exactly equal to (1+r1) (1+r21)

to take into account risks
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Present Value of a Loan

The Term Structure can be reflected in using various “r” terms
for different time periods
Example:
1000 1000
=
(1+r3)3 (1+f1)(1+f2)(1+f3)
Forward Rate Computation
(1+ rn)n = (1+ r1)(1+f2)(1+f3)....(1+fn), n=1,2,…

with f1=r1
20
Spot/Forward rates
Coupons paying bonds to derive rates
Bond Value = C1 + C2
(1+R) (1+R)2
Bond Value = C1 + C2
(1+f1) (1+f1)(1+f2)
d1 = C1 d2 = C2
(1+f1) (1+f1)(1+f2)

21
Term Structure
What Determines the Shape of the Term
Structure ?
1 - Expectations Theory
2 - Liquidity-preference Theory (risk
premium)
3 - Market Segmentation Hypothesis
4 – Preferred habitat Theory

22
Term Structure
–Lutz (1940), Meiselman (1962)
–Investors have homogenous expectations about
future interest rates,
–Investors are risk neutral and rational,
Bt(2)
Strategy 1: Buy Bt(1)
at t
t t+1 t+2
Strategy 2: Buy Bt(2)
at t and sell it
at t+1
Bt(1) Bt+1(1)

23
Term Structure
– Strategy 1: Buy Bt(1) at t
– Strategy 2: Buy Bt(2) at t and sell it at t+1
• Expected sell price: Et[Bt+1(1) ]
In absence of arbitrage opportunity:
B 
Et  =
(1)
1
t +1
⇔ E


1 + Rt (
( 2) 2 
 = 1 + R (1) )
 ( 2)
(1) t (1) t
 B  B  1 + R t +1 

t t

1+ H t(1, 2 )

24
Term Structure
– Strategy 1: Buy Bt(1) at t
– Strategy 2: Buy Bt(2) at t and sell it at t+1
• Expected sell price: Et[Bt+1(1) ]
In absence of arbitrage opportunity: Et H [ t

(1, 2 )
]= R t
(1)
Et 
(
 1 + R ( 2) 2 
t )
= 1 + R (1)
⇔ [ ]
Et Rt(+11) − Rt( 2 ) ≈ Rt( 2 ) − Rt(1)
(1)  t
 1 + Rt +1 

25
Term Structure
premium)
–Hicks (1939),
–Investors are rational,
–Borrowers prefer to issue long term bonds
• Smaller refinancing risk
–Lenders prefer short term bonds
• Smaller risk in terms the capital
⇒ Short term bonds: demand > supply
⇒ Long term bonds: supply > demand

26
Term Structure
premium)
⇒ Short term bonds: demand > supply
⇒ Long term bonds: supply > demand
⇒ liquidity premium: the longer the maturity,
the higher the liquidity premium
Et H [ t
(1, 2 )
]= R t
(1)
+Φ ( 2)
t
( 2) ( 3) (n)
0<Φ t <Φ t << Φ . t

27
Term Structure
–Culbertson (1957, 1965)
–Term structure does not depend on investors’
expectations
–Bond market is segmented
⇒ Bond prices for a given maturity only depend on
the demand and supply for this maturity
⇒ arbitrage between different maturities is not
enough to shift yield curve.

28
Term Structure
–The market segmentation hypothesis
challenges the very notion of term structure,
i.e., the existence of a relation between the
maturities of the yield curve.
⇒ Et H [ t
(1, 2 )
]= R t
(1)
+Φ z ( ) ( 2)
t

29
Term Structure
4 - Preferred habitat Theory
–Modigliani and Sutch (1966)
–Two kind of investors
• Borrowers/lenders with a preferred investment
horizon
• Arbitragers who seek arbitrage opportunities
between different maturities
⇒ Investors leave their preferred habitat if the risk
premium is large enough.
≤
Et H [ t
(1, 2 )
]= R t
(1)
+Φ ( 2)
t
Φ ( 2)
t
≥
0
30
Term Structure
YTM (r)
Inverted
Normal
Flat or Humped
1 5 10 20 30 Year
• Normal yield curve: positive slope
– Investors expect the economy to grow in the future in association with a risk of rising
inflation,
– This expectation generates both
• an expectation that the central bank will rise short term interest rates in the future to slow
economic growth and dampen inflationary pressure
• and the need for a risk premium associated with the uncertainty about the future rate of
inflation and the risk this poses to the future value of cash flows.
– Investors price these risks into the yield curve by demanding higher yields for
maturities further into the future.

31
Term Structure
YTM (r)
Inverted
Normal
Flat or Humped
Year
1 5 10 20 30
• Normal yield curve: (economic growth, rising inflation, uncertainty)
• Inverted yield curve:
 long-term investors think the economy will slow or even decline in the
future and then will settle for lower yields now.
• indicate a worsening economic situation in the future
• investors believe inflation will remain low.
 technical factors such as a flight-to-quality or global economic situations
may cause demand for bonds on the long end of the yield curve causing
rates to fall (e.g. LTCM 1998)

32
Modeling the Term Structure

• Assumption 1: The spot rate r(t) follows a
diffusion process:
dr (t ) = µ r (r (t ), t )dt + σ r (r (t ), t )dZ t
• Assumption 2: The price B(t,s) of a zero
coupon bond only depends on the value of
the spot rate r(τ), t≤τ≤s.
=> B(t,s) = B(t,s,r(t))
• Assumption 3: the market is perfect

33

• Dynamic of the zero-coupon bond:
µB(t,s,r(t)) σB(t,s,r(t))
Recall
σ2
dC = ∂ t C ⋅ dS + ∂ S C ⋅ dS + ∂ SS C ⋅ S 2 dt
2
Ito term

34

• Assume you issue an amount W1 of a zero-
coupon bond maturing at s1 and that you
buy an amount W2 of a zero-coupon bond
maturing a s2. The dynamic of your wealth
W=W2-W1 reads

35

• Consider now that you choose W1 and W2
such that:
the risky term in the dynamic of the wealth

W disappears:

36

• In the absence of arbitrage opportunity, the
instantaneous rate of return of the previous
strategy must be equal to the risk free rate (spot
rate):
or equivalently:
λ(t,r(t)) is the market price of risk

37

• Accounting for the fact that
and that µB(t,s,r)=r(t)+λ(t,r) σB(t,s,r), the value of

the zero coupon bond is solution to:

38

Example 1: one-factor Vasicek model
– The market price of risk is constant: λ(t,r)=λ
– The spot rate follows an Orstein-Uhlenbeck process:
dr = α (γ − r )dt + σdZ t
– The term structure of the zero-coupon bond is:
1 σ2 −α ( s − t ) 2 
B (t , s, r ) = exp  1 − e
α
(
−α ( s − t )
)
⋅ (R∞ − r ) − ( s − t ) R∞ −
4α 3
1− e ( )
 
λσ σ 2
with R∞ = γ + −
α 2α 2

39

– The YTM is:
1 σ 2
R (t , T ) = R∞ +
αT
(
1 − e −αT ⋅ (r (t ) − R∞ ) +)4α 3T
1 − e −αT
( ) 2
σ2
•Normal Yield curve: r (t ) ≤ R∞ −
4α 2
R(t,T)
σ2 σ2
•Humped Yield curve: R∞ − < r (t ) < R∞ +
4α 2 2α 2
σ2
•Inverted Yield curve: r (t ) ≥ R∞ +
2α 2
σ2
R∞ +
2α 2
R∞
σ2
R∞ −
4α 2
T
40

Example 2: Cox-Ingersoll-Ross
– The spot rate follows the process: Ensures the
positivity of r(t)
dr = α (γ − r )dt + σ r dZ t

41

Example 2: Cox-Ingersoll-Ross
– The spot rate follows the process: Ensures the
positivity of r(t)
dr = α (γ − r )dt + σ r dZ t
– The term structure of the zero-coupon bond is:
B (t , s, r ) = A(t , s )e − C ( t , s ) r
2αγ
αγ
  σ2
( )
s
 R∞κe
R∞
 R∞ eκs − 1
A(t , s ) =  , C (t , s ) = ,

κs
(
αγ e − 1 + κ)

(κs
αγ e − 1 + κ )
2αγ
κ= (α + λ )2 + 2σ 2 and R∞ =
α + λ +κ
42

– The YTM is:
1
R (t , T ) = [r (t )C (t , t + T ) − ln A(t , t + T )]
T
r (t ) ≤ R∞
•Normal Yield curve:
R(t,T)
αγ
•Humped Yield curve: R∞ < r (t ) <
α + λ +κ
αγ
•Inverted Yield curve: r (t ) ≥
α + λ +κ
αγ
α + λ +κ
R∞
T
43
Modeling the Forward Rate curve

The forward rate f(t,x) is the interest rate that can be contracted at time t for
instantaneously riskless borrowing or lending at time t+x.
It is a function of the time-to-maturity x, which changes every day.
Value of continuously
reinvested investment
⇔
Spot rate:

44

45
A. Matacz and J.-P. Bouchaud, Explaining the forward interest rate term structure,

F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, The 46
Relative Valuation of Caps and Swaptions: Theory and
Empirical Evidence, The Journal of Finance 56 (6), 2067-
2109.

47

HJM
No-arbitrage condition leads to:
φ is the market
Prof. Dr. Yannick Malevergne www.er.ethz.ch price
D-MTEC Chair of Entrepreneurial of
Risks risks
48
A better model: the “String model”
P. Santa-Clara and
D. Sornette,
The Dynamics of
the Forward
Interest Rate Curve
with Stochastic
String Shocks,
The Review of
Financial Studies
14(1), 149-185
(2001)

49
Example: stochastic string shocks

50

51
String model for interest rate derivatives
Longstaff et al. (2001) have demonstrated the remarkable

modeling and predictive power of the « String model » for
pricing options on interest rates and bonds.
F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, Throwing away a billion

dollars: the cost of suboptimal exercise strategies in the swaptions market
Journal of Financial Economics 62, 39-66 (2001).
F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, The Relative Valuation of Caps
and Swaptions: Theory and Empirical Evidence, The Journal of Finance 56 (6),
2067-2109

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1

Interest Rate Models

Institute of Business Administration (University Jean

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

• The simplest kind of bond is the Zero-

It is the Present Value (at t) of 1$ received at s.

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

• Value of a bond = Present value of its future

Yield-to-maturity (Internal Rate of Return)

Equivalence between continuous and discrete time discounting

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Impact of interest rates on bond price

• If r⇑, present value of future fixed payments⇓

Debt & Interest Rates

Nominal Interest Rate = The rate you actually

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Debt & Interest Rates

Debt & Interest Rates

Real r is theoretically somewhat stable

Inflation is a large variable

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

2 Real Yield on UK 10 yr bonds

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

– Invest $ CN-1xB(t,tN-1) at t  Receive $CN-1 at tN-1

Present value of the Payoff of the bond

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

In the absence of arbitrage opportunity, the knowledge of the

• Term-structure: the sequence of bonds, yields, interest rates

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Yield curve (Feb 2004)

Yield curve: Yield-to-Maturity vs. Maturity

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Yield curve: examples of 18 Jan 2007

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

(1+r2)2 = (1+r1) (1+f2) but not exactly equal to (1+r1) (1+r21)

Present Value of a Loan

Forward Rate Computation

(1+ rn)n = (1+ r1)(1+f2)(1+f3)....(1+fn), n=1,2,…

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

In absence of arbitrage opportunity:

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

In absence of arbitrage opportunity: Et H [ t

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Modeling the Term Structure

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Modeling the Term Structure

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Modeling the Term Structure

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Modeling the Term Structure

the risky term in the dynamic of the wealth

Prof. Dr. Yannick Malevergne www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks