Chapter 5
Chapter Outline
5.1 Types of Rates
5.2 Zero Rates
5.3 Bond Pricing
5.4 Determining zero rates
5.5 Forward rates
5.6 Forward rate agreements
5.7 Theories of term structure
5.8 Day count conventions
Chapter Outline
5.9 Quotations
5.10 Treasury Bond Futures
5.11 Eurodollar futures
5.12 The LIBOR zero curve
5.13 Duration
5.14 Durationbased hedging strategies
5.1 Types of Rates
Treasury rates
LIBOR rates
Repo rates
5.2 Zero Rates
A zero rate (or spot rate), for maturity T is the rate of
interest earned on an investment that provides a
payoff only at time T
Example (Table 5.1, page 95)
Maturity
(years)
Zero Rate
(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
5.3 Bond Pricing
To calculate the cash price of a bond we discount each cash
flow at the appropriate zero rate
In our example, the theoretical price of a twoyear bond
providing a 6% coupon semiannually is
3 3 3
103 9839
0 05 0 5 0 058 1 0 0 064 1 5
0 068 2 0
e e e
e
+ +
+ =
. . . . . .
. .
.
Bond Yield
The bond yield is the discount rate that makes the
present value of the cash flows on the bond equal
to the market price of the bond. aka YTM
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39
The bond yield is given by solving
to get y=0.0676 or 6.76%.
3 3 3 103 9839
0 5 1 0 15 2 0
e e e e
y y y y
+ + + =
. . . .
.
Par Yield
The par yield for a certain maturity is the coupon
rate that causes the bond price to equal its face
value.
In our example we solve
g) compoundin s.a. (with 87 6 get to
100
2
100
2 2 2
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
. c=
e
c
e
c
e
c
e
c
=

.

\

+ +
+ +
Par Yield continued
In general if
m is the number of coupon payments per year,
d is the present value of $1 received at maturity and
A is the present value of an annuity of $1 on each
coupon date
A
m d
c
) 100 100 (
=
5.4 Determining Treasury Zero Rates
Treasury zero rates can be calculated from the
prices of instruments that trade.
One way to do this is the bootstrap method.
To see how this works, consider the following
example:
Sample Data for Determining the Zero Curve (Table
5.2, page 97)
Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
Half the stated coupon is paid every 6 months.
An amount 2.5 can be
earned on 97.5 during 3
months.
The 3month rate is 4
times 2.5/97.5 or
10.256% with quarterly
compounding
This is 10.127% with
continuous
compounding
The Bootstrapping the Zero Curve
Similarly the 6 month and 1 year rates are 10.469%
and 10.536% with continuous compounding
Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
The Bootstrap Method continued
To calculate the 1.5 year rate we solve
to get R = 0.10681 or 10.681%
96 104 4 4
5 . 1 0 . 1 10536 . 0 5 . 0 10469 . 0
= + +
R
e e e
Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 1.50 8 96.0
100 2.00 12 101.6
Similarly the twoyear rate is 10.808%
Zero Curve Calculated from the Data (Figure
5.1, page 98)
9
10
11
12
0 0.5 1 1.5 2 2.5
Zero
Rate (%)
Maturity (yrs)
10.127
10.469 10.536
10.681
10.808
5.5 Forward Rates
The forward rate is the future zero rate implied by
todays term structure of interest rates
Calculation of Forward Rates
Table 5.4, page 98
Zero Rate for Forward Rate
an n year Investment for n th Year
Year ( n ) (% per annum) (% per annum)
1 10.0
2 10.5 11.0
3 10.8 11.4
4 11.0 11.6
5 11.1 11.5
2 105 . 21 . 11 . 1 .
100 100 100
= = e e e e
Formula for Forward Rates
Suppose that the zero rates for maturities T
1
and T
2
are R
1
and R
2
with both rates continuously
compounded.
The forward rate for the period between times T
1
and T
2
is
R T RT
T T
2 2 1 1
2 1
1
2
0 012
2
1 2
1
2
1
o
o
o
t t
t
t
t
. )
Duration of a bond that provides cash flow c
i
at time t
i
is
where B is its price and y is its yield (continuously
compounded)
This leads to
t
c e
B
i
i
n
i
yt
i
=
(
1
y D
B
B
o =
o
Duration
Duration Continued
When the yield y is expressed with compounding
m times per year
The expression
is referred to as the modified duration
m y
y BD
B
+
o
= o
1
D
y m 1+
Convexity
The convexity of a bond is defined as
C
B
B
y
c t e
B
B
B
D y C y
i i
yt
i
n
i
= =
= +
1
1
2
2
2
2
1
2
c
c
o
o o
so that
( )
Duration Matching
This involves hedging against interest rate risk by
matching the durations of assets and liabilities
It provides protection against small parallel shifts in
the zero curve
5.14 Durationbased hedging strategies
Hedging in Interest Rate Futures
A mortgage lender who has agreed to loan
money in the future at prices set today can
hedge by selling those mortgages forward.
It may be difficult to find a counterparty in
the forward who wants the precise mix of
risk, maturity, and size.
Its likely to be easier and cheaper to use
interest rate futures contracts however.
Duration Hedging
As an alternative to hedging with futures or
forwards, one can hedge by matching the
interest rate risk of assets with the interest
rate risk of liabilities.
Duration is the key to measuring interest rate
risk.
Duration measures the combined effect of
maturity, coupon rate, and YTM on bonds
price sensitivity
Measure of the bonds effective maturity
Measure of the average life of the security
Weighted average maturity of the bonds cash
flows
Duration Hedging
Duration Formula
=
=
+
+
=
+ + +
=
N
t
t
t
N
t
t
t
T
r
C
r
t C
D
PV
T C PV C PV C PV
D
1
1
2 1
) 1 (
) 1 (
) ( 2 ) ( 1 ) (
Calculating Duration
Calculate the duration of a threeyear bond that
pays a semiannual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually.
Discount Present Years x PV
Years Cash flow factor value / Bond price
0.5 $40.00 0.96154 $38.46 0.0192
1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Calculating Duration
Duration is expressed in units of time; usually years.
Duration
The key to bond portfolio management
Properties:
Longer maturity, longer duration
Duration increases at a decreasing rate
Higher coupon, shorter duration
Higher yield, shorter duration
Zero coupon bond: duration = maturity
5.25
On August 1 a portfolio manager has a bond
portfolio worth $14 million. The duration of the
portfolio in October will be 7.1 years.
The December Treasury bond futures price is
currently 9112 and the cheapesttodeliver bond
will have a duration 0f 8.8 years at maturity
How should the manager immunize the portfolio
against changes in interest rates over the next two
months?
5.25
The treasurer should short Treasury bond futures
contract.
If bond prices go down, this futures position will
provide offsetting gains.
The number of contracts that should be shorted is
3 . 88
8 . 8 375 , 91
1 . 7 000 , 10
=