Interest Rate Models and

Derivatives
Shumbashava Edington
 Agenda
• Bond fundamentals
– Bond Valuation
– Dollar Value Basis point (DV01)
– Duration
– Convexity
• Theories relating to the yield curve
• The Science of Term Structure Models
• The Evolution of Short Rates and the Shape of the Term Structure
• The Art of Term Structure Models: Drift
• The Art of Term Structure Models: Volatility and Distribution
• Interest Rate Derivatives
– Interest Rate Caps and Floors
– Forward Rates Agreements (FRAs) and Interest rates futures
– Interest Rate Swaps and Swaptions
Bond Fundamentals
Bond Fundamentals
Example: Valuing a Coupon Bond
Bond Price - Yield Curve
Bond Price Quotations
 Discount Factors
• Discount factors are used to determine
present values. The discount function is
denoted as d(t) where t is time in years.
• Suppose the discount factor for the first 180
day coupon period is d(0.5) = 0.92432.
Calculate the price of a bond that pays $108
six months from today.
• Price = 0.92432 x $108 = $99.83
 Calculating Discount Factors using Bond
Prices
• Bonds are securities that promise a future stream of
cash flows, so a series of Treasury Bond prices can be
used to generate the discount function.

• Calculate the following: (i) d (0.5) and (ii) d (1.0)

Calculating Discount Factors using Bond
Prices
Treasury Coupon Bonds and Treasury Strips
• Zero-coupon bonds issued by the Treasury are called STRIPS
(separate trading of registered interest and principal
securities). STRIPS are created by request when a coupon
bond is presented to the Treasury. The bond is "stripped" into
two components: principal and coupon (P-STRIPS and C-
STRIPS, respectively).
• The Treasury can also retire a STRIP by gathering the parts up
to reconstitute, or remake, the coupon bond. C-STRIPS can be
put with any bond to reconstitute, but P-STRIPS are identified
with specific bonds-the original bond that it was stripped
from.
• What this means is that the value of a P-STRIP comes from the
underlying bond. If the underlying was cheap, the P-STRIP will
be cheap. If the underlying was rich, the P-STRIP will also be
rich.
 Treasury Coupon Bonds and Treasury Strips
STRIPS are of interest to investors because:
– Zero-coupon bonds can be easily used to create any type of cash flow stream and
thus match asset cash flows with liability cash flows (e.g., to provide for college
expenses, house-purchase down payment, or other liability funding). This
mitigates reinvestment risk.
– Zero-coupon bonds are more sensitive to interest rate changes than are coupon
bonds. This could be an issue for asset-liability management or hedging purposes.
STRIPS do have some disadvantages, which include the following:
– They can be illiquid.
– Shorter-term C-STRIPS tend to trade rich.ie they tend to have lower spot rates
– Longer-term C-STRIPS tend to trade cheap.ie they tend to have higher spot rates
– P-STRIPS typically trade at fair value.
– Large institutions can potentially profit from STRIP mispricings relative to the
underlying bonds. They can do this by either buying Treasuries and stripping them
or reconstituting STRIPS. Because of the cost involved with stripping
reconstituting, investors generally pay a premium for zero-coupon bonds.
Deriving Discount Factors from SWAP Rates
• In an interest rate swap, payments are exchanged based on a
notional amount. Although this notional amount is never
technically exchanged between counterparties in an interest
rate swap, it is used to determine the size of both the fixed
and floating leg payments.
• If we were to hypothetically exchange the notional amount
at swap maturity, it would be easy to see similarities
between the fixed leg of a swap and a fixed coupon paying
bond, with the fixed leg payments acting like semi-annual
fixed coupon payments and the notional amount acting like
the bond principal payment at maturity (ì.e., its terminal
value).
Deriving Discount Factors from SWAP Rates

• Similarly, if the notional amount was exchanged at swap

maturity, the floating leg of the swap would resemble a
floating rate bond, with semi-annual, floating coupon
payments and a bond principal payment at maturity.
• In an interest rate swap, the fixed receiver (floating
payer) “buys" the fixed leg, and the fixed payer (floating
receiver) "sells" the fixed leg. Thus, we use fixed swap
rates to derive discount factors. For this calculation.
swap rates represent bond coupon payments and the
swap notional amount represents the bond's par value.
Example
Solution
 The Spot Rate Curve
• The spot rate curve is the graph the relationship between spot
rates and maturity. The spot rate curve can be derived from either
a series of STRIPS prices and the comparable discount factors.
• Recall that the t-period discount factor is the present value today
of $1 to be received at the end of period t. For semi-annual
coupon bonds, the t-year discount factor is related to the t-year
spot rate as follows:

• This means that either spot rates or discount factors can be used
to price coupon bonds.
Example
Solution
Conclusion - Bonds
 Zero Coupon Bonds
• A zero-coupon bond is a bond that makes only a single
payment at its maturity date. Our notation for zero coupon
bond prices will mimic that for interest rates. The price of a
bond quoted at time t0, with the bond to be purchased at t1
and maturing at t2, is Pt0 (t1, t2). As with interest rates, we will
drop the subscript when t0 = t1.

• The 1-year zero-coupon bond price of P (0, 1) = 0.943396

means that you would pay $0.943396 today to receive $1 in 1
year. You could also pay P (0, 2) = 0.881659 today to receive
$1 in 2 years and P (0, 3) = 0.816298 to receive $1 in 3 years.
 Zero Coupon Bonds
• The yield to maturity (or internal rate of return) on a zero-coupon
bond is simply the percentage increase in dollars earned from the
bond. For the 1 -year bond, we end up with 1/0.943396 - 1 = 0.06
more dollars per $1 invested. If we are quoting interest rates as
effective annual rates, this is a 6% yield.

• For the zero-coupon 2-year bond, we end up with 1/0.881659 - 1 =

0.134225 more dollars per $1 invested. We could call this a 2-year
effective interest rate of 13.4225%, but it is conventional to quote
rates on an annual basis. If we want this yield to be comparable to
the 6% yield on the 1-year bond, we could assume annual
compounding and get (1 + r (0, 2)) ^2 = 1.134225, which implies that
r (0, 2) = 0.065.
 Zero Coupon Bonds
• In general,

• A zero-coupon bond price is a discount factor: A

zero-coupon bond price is what you would pay
today to receive $1 in the future. If you have a
future cash flow at time t, C. you can multiply it
by the price of a zero-coupon bond, P (0, t), to
obtain the present value of the cash flow.
 Forward Rates
• Forward rates are interest rates that span future periods.
Given the spot rates, it is possible to compute forward
rates implied by that spot curve. The spot rates are the
appropriate rates that an investor should expect to realize
for various periods for a risk-free investment starting today.
• The investor should not be concerned whether the
investment is composed of a single instrument or a series
of shorter investments rolled over consecutively. This is
because, if the risk is the same, the realized return must be
the same regardless of how the investment is packaged.
• This concept is at the core of forward rate analysis.
 Implied Forward Rates
• We now see how column (3) in Table 7. 1 can be computed from
either column (1) or (2). The 1-year and 2-year zero-coupon
yields are the rates you can earn from year 0 to year 1 and from
year 0 to year 2. There is also an implicit rate that can be earned
from year 1 to year 2 that must be consistent with the other two
rates. This rate is called the implied forward rate.

• Suppose we could today guarantee a rate we could earn from

year 1 to year 2. We know that $1 invested for 1 year earns [1 +
r0 (0, l)] and $1 invested for 2 years earns [1 + r0 (0, 2)] ^2. Thus,
the time 0 forward rate from year 1 to year 2, r0 (1, 2), should
satisfy
 Implied Forward Rates

• Figure 7.2 shows graphically how the implied forward rate is

related to 1- and 2-year, yields. If r0 (0, 2) did not satisfy
equation (7.2), then there would be an arbitrage opportunity.
Problem 7.15 asks you to work through the arbitrage. In
general, we have
 Example 7.1
• Using information in Table 7.1, we want to compute the
implied forward interest rate from year 2 to year 3 and the
implied forward price for a 1–year zero-coupon bond
purchased in year 2. The implied forward interest rate, r0 (2,
3), can be computed as
 Coupon Bonds
• Given the prices of zero-coupon bonds-column (1) in Table 7.1-we can
price coupon bonds. We can also compute the par coupon-column (4) in
Table 7. 1-the coupon rate at which a bond will be priced at par. To
describe a coupon bond, we need to know the date at which the bond is
being priced, the start and end date of the bond payments, the number
and amount of the payments, and the amount of principal.
 Example 7.2
• Using the information in Table 7.1, the coupon
on a 3-year coupon bond that sells at par is
 Zeros from Coupons
• We have started with zero-coupon bond prices and deduced the prices of
coupon bonds. In practice, the situation is often the reverse: We observe prices
of coupon bonds and must infer prices of zero-coupon bonds. This procedure in
which zero coupon bond prices are deduced from a set of coupon bond prices is
called bootstrapping.

• Suppose we observe the par coupons in Table 7.1. We can then infer the first
zero-coupon bond price from the first coupon bond as follows:
 
1 = (1 + 0.06) P (0, 1)
• This implies that P (0, 1) = 1 / 1 .06 = 0.943396. Using the second par coupon
bond with a coupon rate of 6.48423% gives us

1 = 0.0648423 P (0, 1) + 1 .0648423 P (0, 2)

 Zeros from Coupons
• Since we know P (0, 1) = 0.943396, we can solve for P (0, 2):

• There is nothing about the procedure that requires the bonds to trade at par. In
fact, we do not even need the bonds to all have different maturities. For
example, if we had a 1 –year bond and two different 3-year bonds, we could still
solve for the three zero-coupon bond prices by solving simultaneous equations.
 Conclusion
• A spot rate is approximately equal to the average of the
forward rates of actual or lower term. As spot rates
increase over time, forward rates are greater than
corresponding spot rates.
• Given an upward-sloping spot rate curve, par rates are
near, but slightly below, corresponding spot rates. This
relationship occurs because the spot rate curve is not flat.
• In general, bond prices will increase with maturity when
coupon rates are above relevant forward rates. A bond's
return will depend on the duration of the investment and
the relationship between spot and forward rates.
Interest Rate Factors
Price Sensitivities Based on Parallel Yield
Curve Shifts – Merits and Demerits
Dollar Value Basis point
Example
 Yield Based DV01
• Similar to DV01 but explicitly assumes that the yield of a
security is the interest rate factor and that the pricing function
is the price yield relationship.
Duration
 Modified Duration

Example
• Suppose there is a 15 year, option free non-callable bond with an annual
coupon of 7% trading at par. Compute and interpret the bond’s duration for a
50 bps increase and decrease in yield.
Effective Duration
Modified Duration and Macaulay Duration –
Another formula
Example
DV01, DURATION AND YIELD
 Convexity
• Duration is a good approximation of price
changes for option free bond, but it is only good
for relatively small changes in interest rates.
• Like DV01, duration is a linear estimate since it
assumes that the price change will be the same
regardless of whether interest rates goes up or
down.
• As rates grow larger, the curvature of the
bond/price relationship becomes more
important meaning that a linear estimate will
contain errors
 Convexity
• Convexity refers to the curvature of a bond’s
price-yield relationship.
• Convexity is always positive for regular
coupon-paying bonds.
• Finally, the property of positive convexity may
also be thought of as the property that DV01
falls as rates increase
Convexity
Convexity
 Four important properties of Convexity
• As yield decrease(increase), the duration of a bond
increases(decreases) at an increasing(decreasing) rate.
Since convexity measures the rate of change of duration,
it increases(decreases) as yields decrease(increase).
• Holding yield constant, the lower the coupon, the higher
the duration and the greater the convexity.
• Holding both yield and duration constant, the lower the
coupon, the lower the convexity. This rule also suggest
that convexity is also a measure of dispersion of cash
flows.
• Convexity increases at an increasing rate as duration
increases.
 Binomial Model
• A binomial model is a model that assumes
that interest rates can take only one of two
possible values in the next period.
• This interest rate model makes assumptions
about interest rate volatility along with a set
of paths that interest rates may follow over
time. This set of possible interest rate paths is
referred to as an interest rate tree.
Binomial Model
 Binomial model
• A node is a point in time when interest rates can take one
of two possible paths – an upper path U or a lower path L.
• There is one underlying rule governing the construction of
an interest rate tree: the values for on-the-run issues
generated using an interest rate tree should prohibit
arbitrage opportunities.
• This means that the value of an on the run issue produced
by the interest tree must equal its market price.
• In accomplishing this, the interest rate tree must maintain
the interest rate volatility assumption of the underlying
model.
 Backward Induction
• Backward induction refers to the process of valuing a bond
using a binomial interest rate tree.
• The term backward is used because in order to determine
the value of a bond at node 0, you need to know the values
that the bond can take at node 1.
• But to determine the values of the bond at node 1, you need
to know the possible values of the bond at node 2 and so on.
• the value of a bond at a given node in a binomial tree is the
average of the present values of the two possible values
from the next period, because the probabilities of an up
move and a down move are both 50%.
 Example
• Consider a binomial tree for a $100 face value, 7% annual coupon bond,
with two year remaining to maturity and a market price of $102.999.

• Note that the value of the bond at any node is the present value of the two
possible values in the next period.
• The appropriate discount rate is the forward rate associated with the node
under analysis
Binomial tree
Risk Neutral Pricing
Using the Risk Neutral Interest Rate
Steps for Valuing an Option on a Fixed
Income Instrument
 EXAMPLE
• Assume that you want to value a European call option with two years to maturity
and a strike price of $100. The underlying is a 7%, annual coupon bond with 3
years to maturity.
• Assume that the risk neutral probability of an up move is 0.76 in year 1 and 0.6. in
year 2.

• Fill in the missing data in the binomial tree, and calculate the value of the
European call option.
Example
 Example

• Consider a 2-year, 7% coupon, putable bond

that is putable in one year at a price of
100.Further assume that the put option will
be exercised if the value of the bond is less
than 100.Calculate the value of the putable
bond.
BSM Model and Valuation