Chapter 4

Interest Rates and FRA

1
Types of Rates
Treasury rates
Overnight rates
Repo rates
LIBOR

2
Treasury Rate
Rate on instrument issued by a government
in its own currency

3
Overnight Rates
Unsecured borrowing and lending between
banks as they adjust the reserve requirements
they are required to keep with the central bank
Referred to as the Fed Funds Rate in the U.S.
The effective fed funds rate is the weighted
average of the rates on brokered transactions
Central bank may intervene with its own
transactions to raise or lower the overnight rate

4
Repo Rate
Repurchase agreement is an agreement
where a financial institution that owns
securities agrees to sell them for X and buy
them bank in the future (usually the next day)
for a slightly higher price, Y
The financial institution obtains a loan.
The rate of interest is calculated from the
difference between X and Y and is known as
the repo rate
5
LIBOR
LIBOR is the rate of interest at which a AA-
rated bank estimates it can borrow money on
an unsecured basis from another bank at
11am.
Several currencies and maturities
There have been some suggestions that
banks manipulated LIBOR during certain
periods. Why would they do this?

6
LIBOR Phase Out
Regulators plan to phase out LIBOR by the
end of 2021 and replace it with rates based
on transactions observed in the overnight
market.
The new reference rates (e.g. for a 3-month
period) will be calculated at the end of the
period as the compounded overnight rates for
that period

7
The New Reference Rates
US dollar: SOFR (secured overnight funding
rate
GBP: SONIA (sterling overnight index
average
EU: ESTER (euro short-term rate)
Switzerland: SARON (Swiss average
overnight rate)
Japan: TONAR (Tokyo average overnight
rate)
8
The New Reference Rates
SOFR is calculated from repos and is
therefore a secured rate
The others are calculated from unsecured
overnight borrowing and lending between
banks

9
The Risk-Free Rate
The Treasury rate is considered to be artificially
low because
Banks are not required to keep capital for Treasury
instruments
Treasury instruments are given favorable tax treatment
in the US
The new reference rates are considered to be
proxies for the risk-free rate
Other “risky” reference rates incorporating a credit
spread may be developed
10
Impact of Compounding (Table 4.1)
When we compound m times per year at rate R an
amount A grows to A(1+R/m)m in one year

Compounding frequency Value of $100 in one year at 10%

Annual (m=1) 110.00
Semiannual (m=2) 110.25
Quarterly (m=4) 110.38
Monthly (m=12) 110.47
Weekly (m=52) 110.51
Daily (m=365) 110.52

11
Measuring Interest Rates
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

12
Continuous Compounding (equation 4.2)
In the limit as we compound more and more
frequently we obtain continuously compounded
interest rates
$100 grows to $100eRT when invested at a
continuously compounded rate R for time T
$100 received at time T discounts to $100e-RT at
time zero when the continuously compounded
discount rate is R

13
14
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

15
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

16
Example (Table 4.2)
Maturity (years) Zero rate (cont. comp.
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

17
18
19
20
21
Data to Determine Zero Curve
(Table 4.3)

Bond Principal Time to Coupon per Bond price ($)

Maturity (yrs) year ($)*
100 0.25 0 99.6
100 0.50 0 99.0
100 1.00 0 97.8
100 1.50 4 102.5
100 2.00 5 105.0

* Half the stated coupon is paid each year

22
The Bootstrap Method
An amount 0.4 can be earned on 99.6 during
3 months.
Because 100=99.4e0.01603×0.25 the 3-month
rate is 1.603% with continuous compounding
Similarly the 6 month and 1 year rates are
2.010% and 2.225% with continuous
compounding

23
24
Zero Curve Calculated from the
Data (Figure 4.1)
3.00% Zero Rate
(% per annum)
2.50%

2.00%

1.50%

1.00%

0.50%
Maturity (years)
0.00%
0 0.5 1 1.5 2 2.5 3

25
Forward Rates
The forward rate is the future zero rate
implied by today’s term structure of interest
rates

26
27
Application of the Formula (Table
4.5)

Year (n) Zero rate for n-year Forward rate for nth
investment year
(% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.5 6.5

28
29
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

30
If a large investor thinks that rates in the
future will be different from today’s forward
rates, there are many trading strategies that
the investor will find attractive.
One of these involves entering into a contract
known as a forward rate agreement.

31
Forward Rate Agreement
A forward rate agreement (FRA) is an OTC
agreement that the actual rate applicable to a
certain period will be exchanged for a
predetermined rate, RK, with both being
applied to a predetermined principal

32
Forward Rate Agreement: Key
Results
An FRA can be valued by assuming that the forward
interest rate, RF , is certain to be realized
This means that the value of an FRA is the present
value of the difference between the interest that would
be paid at interest at rate RF and the interest that would
be paid at rate RK

33
Example
An FRA entered into some time ago states that a
company will receive 5.8% (s.a.) and pay SOFR
on a principal of $100 million starting in 1.5 years
Forward SOFR for the period between 1.5 and 2
years is 5% (s.a.)
The 2 year (SOFR) risk-free rate is 4% with
continuous compounding
The value of the FRA (in $ millions) is
100×(0.058-0.050) ×0.5×e-0.04×2=0.3692

34
FRA

35
36
37
38
39
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?

40
41
Theories of the Term Structure
Expectations Theory: forward rates equal
expected future zero rates
Market Segmentation: short, medium and
long rates determined independently of
each other
Liquidity Preference Theory: forward rates
higher than expected future zero rates

42
Liquidity Preference Theory
(Table 4.7)
Suppose that the outlook for rates is flat and
you have been offered the following choices
Maturity Deposit rate Mortgage rate
1 year 3% 6%
5 year 3% 6%

Which would you choose as a depositor?

Which for your mortgage?

43
Liquidity Preference Theory cont
(Table 4.8)
To match the maturities of borrowers and
lenders a bank has to increase long rates
above expected future short rates
In our example the bank might offer
Maturity Deposit rate Mortgage rate

1 year 3% 6%

5 year 4% 7%

44