Measuring Interest Rates, Zero Rate and Forward Rate

Prof(Dr.) Harsh Vardhan

 Objective

 Measuring Interest Rates

 Zero Rates
 Bond Pricing
 Determining Treasury Zero Rates
 Forward Rates

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 Measuring Interest Rates
 Let an amount A is invested for n years at an interest rate of R per
[Link] the rate is compounded every year ,the terminal value of
investment is A[1+R]n
 If the rate is compounded m times per annum, the terminal value of the
R nm
investment is A[1+ ]
m
 The compounding frequency used for an interest rate is the unit of
measurement
 The difference between quarterly and annual compounding is analogous
to the difference between miles and kilometers.

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 Continuous Compounding
 If Compounding frequency tends to infinity it is known as Continuous
Compounding.
𝑅 𝑛𝑚
 lim A 1 + =A𝑒 𝑅𝑛 ,where e =2.71828
𝑚→∞ 𝑚
 Prove that daily compounding is approximately equal to continuous
compounding.
R
 It has been seen in the equation A[1+ ]nm , if m=365,A =$100,R=10%,n=1
m
then MV=$110.5136 ≃ $110.51
 For continuous compounding A becomes A𝑒 𝑅𝑛 ,put A=100,R=10%,n=1
then MV=$110.51
 This implies that daily compounding is approximately equal to continuous
compounding.
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Continuous Compounding

 Compounding a sum of money at a continuous compounded rate R for n

years involves it by multiplying by 𝑒 𝑅𝑛 .
 Discounting at a continuous compounded rate R for n years involves
multiplying by 𝑒 −𝑅𝑛 .
 Thus $100 grows to $100𝑒 𝑅𝑇 when invested at a continuously compounded
rate R for time T.
 $100 received at time T discounts to $100 𝑒 −𝑅𝑇 at time zero when the
continuously compounded discount rate is R.

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 Conversion Formulas
Define:
Rc : Continuously Compounded rate
Rm : Equivalent rate with compounding m times per year
As Rm is equivalent rate of Rc
R 𝑛 Rm nm
Therefore , A𝑒 c = A[1+ ] , by simplification
m
𝑅𝑚
The formula for conversion : Rc= mln[ 1+ ] -----(1)
𝑚
Rc
Rm= m[𝑒 𝑚 -1] ------(2). [ln=Loge]

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 Equation 1 & 2 can be used to convert a rate with continuous
compounding frequency m times per annum to a continuously
compounded rate and vice versa.
 For pricing Derivatives continuous compounding is followed.
 Futures and Forwards rates are same for short duration.

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 Problems 3/11 A
1. Let an interest rate that is quoted as 10% per annum with semi-annual
compounding. What is the equivalent rate with continuous compounding ?
2. If a lender quotes the interest rate on loans as 8% per annum with
continuous compounding, and the interest is paid quarterly. What is
equivalent compounding rate paid quarterly?
3. What rate of interest with continuous compounding is equivalent to 15% per
annum with monthly compounding?
4. A deposit account pays 12% per annum with continuous compounding but
interest is actually paid quarterly. How much interest will be paid each
quarter on a $ 10,000 deposit?
5. A Bond has face value $100 that has a life of 18 months and pays a coupon
of 8% annum ,the yield is 10.4% per annum. What is the bond’s price. Rates
are quoted with semi -annual compounding?
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 Zero Rates
 The n-year Zero Rate (short for Zero-Coupon Rate) is the rate of interest
earned on an investment that starts today and lasts for n years.
 All interest and principal is realized at the end of n years. There are no
intermediate payments.
 The n-year Zero Rate is sometimes also referred to as the n-year spot rate
or just n -year zero .
 The five-year Treasury zero rate with continuous compounding (cc) is
quoted as 5% per annum.
 This means that $100, if invested at the risk-free rate for five years, would
grow to 100* e0.05*5 = $ 128.40

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 Bond Pricing
 Most Bonds provide coupons periodically. A Bond’s principal which is
known as par value or face value is received at the end of its life.
 The theoretical price of a Bond can be calculated as the Present Value
of all cash flows that will be received by the owner of the Bond.
 Some times Bond trader use the same discount rate for all the cash
flows underlying a bond ,but a more accurate approach is to use the
appropriate Zero rate for each cash flow.

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 Example
 Suppose that a two-year Treasury Bond with a Principal of $I00
provides coupons at the rate of 6% per annum semiannually. Treasury
zero rates with continuous compounding[cc] are given below.
 What is theoretical price of the bond? [Use formula for A𝑒 −Rc 𝑛 to
compute price of the Bond]

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 Bond Pricing

 To calculate the cash price of a Bond we discount each cash flow at the
appropriate zero rate
 To calculate the present value of the first coupon of $3, we discount it at 5.0% for six
months,
 To calculate the present value of the second coupon of $3, we discount it at 5.8% for
one year; and so on.[A𝑒 −Rc 𝑛 ]

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 Theoretical Price of the Bond 3/11 B

The theoretical price of a two-year bond providing a 6% coupon

semiannually is:
3e(-0.05*0.5) +3e(-0.058*1.0) +3e(-0.064*1.5) +103e(-0.068*2.0) =$98.39
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 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.
 Suppose that the market price of the bond in our example equals its
theoretical price of $98.39
 The bond yield (continuously compounded) is given by solving
3e(-y*0.5) +3e(-y*1.0) +3e(-y*1.5) +103e(-y*2.0) =$98.39
to get y=0.0676 or 6.76%.[by trial &error]

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 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

c  0.050.5 c  0.0581.0 c  0.0641.5

e  e  e
2 2 2
 c   0.0682.0
 100  e  100
 2
to get c=6.87
Thus two year par yield is 6.87% with semiannual compounding or
6.87% continuous compounding.
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 A Useful Fact
 When interest rates are continuously compounded and rates of
successive time periods are combined ,the overall equivalent rate is
simply the average rate during the whole period.
 An important property of exponential function is 𝑒 𝑥 𝑒 𝑦 = 𝑒 𝑥+𝑦

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 Suppose an investor invests $100 for 5 years .The rate of interest is 5% for
two years and 7% for the last two years which is expressed in cc.

 After two years $ 100 grows to 100 𝑒 0.05∗2 =$110.52

 During the next two years $110.52 grows to 110.52 𝑒 0.07∗2 =$127.13

 The value at the end of four years can be written as

 100 𝑒 0.05∗2 𝑒 0.07∗2 =100𝑒 0.05∗2 +(0.07∗2)

= 100 𝑒 2∗(0.05+0.07) =100𝑒 2∗(0.12)
=100𝑒 0.06∗4

 This shows that continuously rates of 5 % for two years and 7% for two years
averages to 6% for four years.
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 Determining Treasury Zero Rates

 In our previous example we have assumed Treasury Zero rates.

 Now we wish to calculate these.
 Treasury Zero Rates are calculated from T- bills and coupon bearing Bonds by
Bootstrap method.
 Table in the next slide provides prices of five Bonds out of which first three
are non- coupon bearing.
 Determine Zero Rates using Bootstrap method.

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 Determining Treasury Zero Rates
Bond Time to Annual* Bond Cash
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 assumed to be paid every six months

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 The Bootstrap Method
 An amount 2.5 can be earned on 97.5 during 3 months.
 The 3-month rate is 4 times 2.5/97.5 or 10.256% with quarterly
compounding
 This is 10.127% with continuous compounding
 Similarly the 6 month and 1 year rates are 10.469% and 10.536% with
continuous compounding

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 The Bootstrap Method continued
 To calculate the 1.5 year rate we solve
0.104690.5 0.105361.0  R1.5
4e  4e  104e  $96

to get R = 0.10681 or 10.681%

 Similarly the two-year rate is $10.808%

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Treasury Zero Rates

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 Zero Curve Calculated by Bootstrap
Chart showing zero rate (Y - axis) as a function of maturity(X-axis is known as zero curve.

Assumptions:
1. Zero curve is linear between the points determined using Bootstrap method.
2. As the Zero curve is linear between two points ,Using Bootstrap method ; 1.25 years zero
rate will be 0.5*10.536% +0.5*10.681%= 10.6085%
3. Zero curve is horizontal prior to first point and horizontal beyond last point. 23
 Why Boot Strapping method is used??
 T-Bills are issued by the government , but they do not have maturities
greater than one year.
 As a result ,boot strapping method is used to fill in interest rates for
Zero coupon securities greater than 1 year.
 It is important to remember that the bootstrapping method equals
T-bills value of Zero coupon components that form the security.

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 Forward Rates
 Forward rates are rates applicable to futures periods of time implied by today's zero
rates.
 Forward interest rates are the rates of interest implied by current zero rates for
periods of time in the future. The rates are assumed to be continuously
compounded.
 Forward rate is rate applicable to a financial transaction that will take place in the
future.
 Suppose that the zero rates for time periods T1 and T2 are R1 and R2 with both rates
continuously compounded.
 The forward rate for the period between times T1 and T2 is:

R2T2 − R1T1
RF =
T2 − T1

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 Calculation of Forward Rates

n-year Forward Rate

zero rate for n th Year
Year ( n ) (% per annum) (% per annum)

1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5

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 R2T2 − R1T1
 RF =
T2 − T1
 R1=3 T1=1
 R2=4 T2=2; then RF=5
 R2=4 T2=2
 R3=4.6 T3=3; then RF=5.8
 R3=4.6 T3=3
 R4=5.0 T4=4; then RF=6.2
 R4=5.0 T4=4
 R5=5.3 T5=5; then RF=6.5

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 Upward vs Downward Sloping
Yield Curve
 For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield

 For a downward sloping yield curve

Par Yield > Zero Rate > Fwd Rate

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 Forward Rate
 Forward Rate of interest implied by the zero rate for the period of
time between the end of 1st year and end of the 2nd year.
 In our example Forward rate for second year is calculated from one
year Zero rate of 3% per annum & 2nd year zero interest of 4% per
annum.
 It is the rate of interest for year 2 when combined with 3% per annum
for year 1, gives 4% overall for two years.

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Thanks

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