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Interest Rates
Rm m e Rc / m 1
Options, Futures, and Other Derivatives 8th Edition,
Copyright © John C. Hull 2012 10
Examples
10% with semiannual compounding is
equivalent to 2ln(1.05)=9.758% with
continuous compounding
8% with continuous compounding is
equivalent to 4(e0.08/4 -1)=8.08% with quarterly
compounding
Rates used in option pricing are nearly
always expressed with continuous
compounding
Options, Futures, and Other Derivatives 8th Edition,
Copyright © John C. Hull 2012 11
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
(100 100 d )m
c
(in our example, m = 2, dA= 0.87284, and A =
3.70027)
*
Half the stated coupon is paid each year
10.68 10.808
10.469 10.53 1
10 6
10.127
Maturity (yrs)
9
0 0.5 1 1.5 2 2.5
Options, Futures, and Other Derivatives 8th Edition,
Copyright © John C. Hull 2012 21
Forward Rates
The forward rate is the future zero rate
implied by today’s term structure of interest
rates
in 1.5 years
100 (0.04 0.055) 0.5 0.75
The transaction might be settled at the one-year point for
an equivalent payoff of
0.75
0.730
1.0275
Options, Futures, and Other Derivatives 8th Edition,
Copyright © John C. Hull 2012 32
Duration (page 89-90)
Duration of a bond that provides cash flow ci
at time ti is
ci e yti
n
D ti
i 1 B
B
Dy
B
BDy
B
1 y m
The expression
D
1 y m
is referred to as the “modified duration”
Options, Futures, and Other Derivatives 8th Edition,
Copyright © John C. Hull 2012 35
Bond Portfolios
The duration for a bond portfolio is the weighted
average duration of the bonds in the portfolio with
weights proportional to prices
The key duration relationship for a bond portfolio
describes the effect of small parallel shifts in the yield
curve
What exposures remain if duration of a portfolio of
assets equals the duration of a portfolio of liabilities?
1 2B
c t
i 1
2 yti
i i e
C 2
B y B
B 2
1 year 3% 6%
5 year 4% 7%