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University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FNCE 4040– Derivatives
Chapter 4
Interest Rates
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Goals
• Discuss the types of rates needed for
Derivative Pricing
• Continuous Compounding
• Yield Curves
• Risk
• Forward Rate Agreements (FRA)
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Types of Rates
• For the purpose of this class there are three
types of interest rates that are relevant
– LIBOR
– Risk-free rates
– Interest Rates on collateral
• Important but out of scope rates include:
– Treasuries
– Overnight Interest Rate Swaps (OIS)
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR
• London Interbank Offered Rate
– This is the rate of interest at which a bank is
prepared to borrow from another bank.
– It is compiled for a variety of maturities ranging
from Overnight to 1 year
– It exists on all 5 currencies – CHF, EUR, GBP,
JPY and USD
– It is compiled once a day ICE Benchmark
Administration (IBA)
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR Process
• Once a day major banks submit the answer
to the following question
“At what rate could you borrow funds, were
you to do so by asking and then accepting
inter-bank offers in a reasonable market size
just prior to 11am London time?”
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Uses of LIBOR
• LIBOR rates are used for
– Interest Rate Futures • This is a futures contract whose price is derived by the interest
paid on 3-Month LIBOR
– Interest Rate Swaps • These are derivative instruments that “swap” LIBOR for fixed
interest rates generally for three or six month period. The maturity
of these tends to be 3 to 50 years
– Mortgages • Some Adjustable Rate Mortgages are linked to LIBOR rates
– Benchmark rate for short-term borrowing in the market.
– There has been a scandal surrounding LIBOR for the past
few years. If interested see the appendix.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
The Risk-Free Rate
• Derivatives pricing originally depended upon
a “risk-free” rate – The risk-free rate traditionally used by derivatives
practitioners was LIBOR
– Treasuries are an alternative but were
considered to be artificially low for a number of
reasons • Treasury bills and bonds must be purchased by financial
institutions to satisfy a variety of regulatory requirements.
Increases demand and decreases yield
• The amount of capital a bank has to have in order to support an
investment in treasury bills and bonds is lower
• Treasuries have a favorable tax treatment
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
The Risk-Free Rate
• In this course we will generally assume that
risk-free rates exist and they will be given to
you.
• We will assume that LIBOR is the risk-free
rate
• We will give you rates.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Collateral Based Discounting
• Derivatives pricing theory has moved to
Collateral Based Discounting – The yield curve relevant for discounting depends
on the collateral agreement
– Every derivatives contract might have a different
yield curve
• When we discuss pricing we will work through
at least one collateralized example
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
THE YIELD CURVE
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Yield Curve
• When pricing derivatives we will need a yield
curve.
• For our purposes a yield curve will consist of – Yields to specified maturities,
– A methodology for interpolating missing yields,
– A methodology for calculating forward rates
(rates that are for borrowing/lending starting in
the future)
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Theories of the Term Structure
• Liquidity Preference Theory: forward rates
higher than expected future zero rates
• Market Segmentation: short, medium and
long rates determined independently of each
other
• Expectations Theory: forward rates equal
expected future zero rates
– The Derivatives market uses this theory.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
CONTINUOUSLY
COMPOUNDED ZERO RATES
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Continuous Compounding
• The compounding frequency used for an
interest rate is the unit of measurement
• All else being equal, a more frequent
compounding frequency results in a higher
value of the investment at maturity
• In this class interest rates will be quoted as
continuously compounded zero rates
– Except when we are discussing a specific
instrument or market – for example LIBOR or
swap rates.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Continuous Compounding
• 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
• Continuous compounding means that an investment
is instantaneously reinvested.
• In practical terms this means – $100 grows to $100 × 𝑒𝑅𝑐𝑇 when invested at a
continuously compounded rate 𝑅𝐶 to time 𝑇
– Conversely, $100 paid at time 𝑇 has a present value of
$100 × 𝑒−𝑅𝑐𝑇, when the continuously compounded
discount rate to time 𝑇 is 𝑅𝑐
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Practice
Maturity
(years)
Continuously
Compounded
Zero Rate
Present
Value
Future
Value
1 4.0000% 961 1,000
2 3.0000% 2,000 2,124
1.5 6.0000% -6,398 -7,000
3 1.5000% 4,000 4,184
Remember: PV = 𝐹𝑉 ∗ 𝑒−𝑅𝑐𝑇
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Other Interest Rates
• The quoting convention for quoted interest
rates involves a daycount convention.
• Through this one can compute the interest
owed.
• There are two examples we will use in class – ACT/360 – The interest owed is
𝑟𝑎𝑡𝑒 ×𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
360
– ACT/365 – The interest owed is
𝑟𝑎𝑡𝑒 ×𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
365
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Start
(days)
End
(days) Rate
Daycount
Basis Notional Interest
0 365 3.00% 360 1,000,000 30,417
0 365 4.00% 365 1,000,000 40,000
182 365 3.00% 360 1,000,000 15,250
180 290 2.00% 365 1,000,000 6,027
Practice
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 × 𝑟𝑎𝑡𝑒 ×𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
𝐷𝑎𝑦𝑐𝑜𝑢𝑛𝑡
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Conversion
• We will often have rates given in a particular
form and have to convert to another.
• We can do this by computing the investment
return from the given rate and using this to
compute the unknown rate, or equating PVs:
𝑒𝑟𝑐𝑐∗𝑑𝑎𝑦𝑠/365 = 1 + 𝑟𝐴𝐶𝑇/360𝑑𝑎𝑦𝑠
360
𝑃𝑉 = 𝑒−𝑟𝑐𝑐∗𝑑𝑎𝑦𝑠/365 =1
1 + 𝑟𝐴𝐶𝑇/360𝑑𝑎𝑦𝑠360
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Practice
Start End ACT/360
Rate
ACT/365
Rate
C. comp.
Rate
0 365 3.00% 3.0417% 2.9963%
0 365 4.00% 4.0556% 3.9755%
182 365 3.00% 3.0417% 3.0187%
1 + 𝑟𝐴𝐶𝑇/360𝑑𝑎𝑦𝑠
360= 1 + 𝑟𝐴𝐶𝑇/365
𝑑𝑎𝑦𝑠
365= 𝑒𝑟𝑐𝑐∗𝑑𝑎𝑦𝑠/365
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
INTERPOLATION BETWEEN
RATES
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Interpolation
• When interpolating between rates we will
linearly interpolate continuously compounded
zero rates.
• The advantages of doing this are:
– It is easy to explain and implement
– It has great risk properties
• Sophisticated spline techniques are common
in the market.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Linear Interpolation
• If we know continuously compounded zero
rates 𝑧1 and 𝑧2 for two times 𝑡1 and 𝑡2 then
for time 𝑡 between 𝑡1 and 𝑡2 we define
𝑟 𝑡 = 𝑟1 +𝑟2 − 𝑟1𝑡2 − 𝑡1
𝑡 − 𝑡1
𝑡1 𝑡2
𝑟1
𝑟2
𝑡
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Practice
Time 1
years
Rate 1
cc zero
Time 2
years
Rate 2
cc zero
Maturity
years Rate
1 4.0000% 2 5.0000% 1.5 4.500%
1.5 2.0000% 2 1.5000% 1.8 1.700%
2 1.0000% 3 2.0000% 2.2 1.200%
𝑟 𝑡 = 𝑟1 +𝑟2 − 𝑟1𝑡2 − 𝑡1
𝑡 − 𝑡1
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Forward Rates
• The forward rate is the future zero rate
implied by today’s term structure of
interest rates
𝑒𝑓𝑛×(𝑇2−𝑇1)
𝑒𝑅2×𝑇2
𝑒𝑅1×𝑇1
𝑒𝑅1×𝑇1𝑒𝑓𝑛×(𝑇2−𝑇1) = 𝑒𝑅2×𝑇2
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Formula for Forward Rates
• 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
12
1122
TT
TRTR
• This formula is only approximately true when
rates are not expressed with continuous
compounding
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Practice
Time 1
years
Rate 1
cc zero
Time 2
years
Rate 2
cc zero
Forward Rate
between 𝒕𝟏 and 𝒕𝟐
1 4.0000% 2 5.0000% 6.0000%
1.5 2.0000% 2 1.7500% 1.0000%
2 1.0000% 3 2.0000% 4.0000%
𝐹1,2 =𝑅2𝑇2 − 𝑅1𝑇1𝑇2 − 𝑇1
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Industry Calc. of Rate Sensitivity: dv01
• Traders in practice use dv01: dollar value of
1bp increase in rates
• Shock interest rates by +1bp and compute
dollar change dv01
• Also compute bucketed dv01 – Shock interest rates by 1bp at various tenor
buckets
– Compute dollar impact of each individual shock
– You obtain a term structure of dv01s
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Example
• Consider an investment which pays
$1,000,000 in 1-years time. The one-year
continuously compounded zero rate is 3.00%.
• The present value of this investment is:
𝑃𝑉 = $1,000,000 ∙ 𝑒−0.03 = $970,446.53
• If interest rates increase by one basis-point
then the new PV will be:
𝑃𝑉 = $1,000,000 ∙ 𝑒−0.0301 = $970,348.49
• Thus the dv01 is -97.04 dollars.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Practice
Amount C.C.
Zero rate Maturity Original PV Bumped PV dv01
1,000,000 3.000% 1 $ 970,445.53 $ 970,348.49 $(97.04)
1,000,000 4.000% 1 $ 960,789.44 $ 960,693.37 $(96.07)
1,000,000 3.000% 2 $ 941,764.53 $ 941,576.20 $(188.33)
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FORWARD RATE AGREEMENT
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Forward Rate Agreement (FRA)
• A Forward Rate Agreement (FRA) is an OTC
agreement such that a certain interest rate
will apply to either borrowing or lending a
principal over a specified future period of
time.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Example
• For example a bank agrees to lend 1m USD
for 1 year starting in 1 year at an interest rate
of 3%. The rate is quoted with an ACT/360
daycount basis.
Year 1 Year 2
today
1𝑚 𝑈𝑆𝐷
1𝑚 𝑈𝑆𝐷
$1𝑚365
3603.00% = 30,416.67
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FRA Mechanics / Valuation – part 1
• From the lender’s viewpoint
• A loan of 𝑁 from 𝑇1 to 𝑇2 at an agreed rate 𝑅𝐾
• Let 𝐷 be the daycount fraction from 𝑇1 to 𝑇2
– For an FRA 𝐷 =𝐷𝑎𝑦𝑠 𝑇2 −𝐷𝑎𝑦𝑠(𝑇1)
360
𝑇1 𝑇2 today
Interest owed:
𝑁 × 𝑅𝐾 × 𝐷
𝑁
𝑁
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
𝑃𝑉 = −𝑁 ∙ 𝑒−𝑟1𝑇1 +𝑁 ∙ 1 + 𝑅𝐾 ∙ 𝐷 ∙ 𝑒−𝑟2𝑇2
FRA Mechanics / Valuation – part 1
• We can value the FRA given the continuously
compounded zero rates 𝑟1 and 𝑟2.
𝑇1 𝑇2 today
Interest owed:
𝑁 ∙ 𝑅𝐾 ∙ 𝐷
𝑁
𝑁
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
The Fair FRA Rate
• The fair FRA rate 𝑅𝐹 is the rate such that the
sum of the PV of both cash flows is zero:
𝑁𝑒−𝑟1𝑇1 = 𝑁 1 + 𝑅𝐹𝐷 𝑒−𝑟2𝑇2
• You can use the above to solve for 𝑅𝐹:
𝑒−𝑟1𝑇1 = 1 + 𝑅𝐹𝐷 𝑒−𝑟2𝑇2
𝑅𝐹 =𝑒 𝑟2𝑇2−𝑟1𝑇1 − 1
𝐷
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
The Fair FRA Rate
• We know that the PV of a loan from 𝑇1 to 𝑇2
at an agreed rate 𝑅𝐾 with daycount fraction 𝐷
from 𝑇1 to 𝑇2 is
𝑃𝑉 = −𝑁𝑒−𝑟1𝑇1 +𝑁 1 + 𝑅𝐾𝐷 𝑒−𝑟2𝑇2
• Combine this with the definition of the fair rate
from the previous page and obtain:
𝑃𝑉 = −𝑁 1 + 𝑅𝐹𝐷 𝑒−𝑟2𝑇2 +𝑁 1 + 𝑅𝐾𝐷 𝑒
−𝑟2𝑇2
𝑷𝑽 = 𝑵 𝑹𝑲 − 𝑹𝑭 𝑫𝒆−𝒓𝟐𝑻𝟐
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Forward Rate Agreement (cont.)
• Equivalent to an agreement where interest at
a predetermined rate, RK is exchanged for
interest at the market rate
• Value an FRA by assuming that the forward
rate RF, is certain (has been discovered)
• So the value of an FRA is the PV of the
difference between:
– the interest that would be paid at rate RF and
– the interest that has to be paid at rate RK
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FRA Mechanics / Valuation – part 2 • A loan from 𝑇1 to 𝑇2
• From the lender’s viewpoint
𝑇1 𝑇2
Fair rate now for
period 𝑇1, 𝑇2 = 𝑅𝐾
today
Interest owed:
𝑁 × 𝑅𝐾 × 𝑇2 − 𝑇1
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Think of Mark-To-Market as the cost to offsetting
your position
FRA Mechanics / Valuation – part 2
Interest owed:
𝑁 × 𝑅𝐾 × 𝑇2 − 𝑇1
𝑒−𝑅2×𝑇2
𝑇1 𝑇2 today
Fair rate for period
𝑇1, 𝑇2 moves to 𝑹𝑭
Interest now prevailing:
𝑁 × 𝑹𝑭 × 𝑇2 − 𝑇1 Take the difference
and PV
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FRA example 1
• For example a bank agrees to lend 1m USD
for 1 year starting in 1 year at an interest rate
of 3%. The rate is quoted with an ACT/360
daycount basis.
• Assume that the interest rates are as follows:
Maturity
Continuously Compounded
Zero Rate
1 2.50%
2 2.60%
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
cc zero PV
2.50% -975,310
2.60% 978,205
FRA example 1 – Cashflows
Year 1 Year 2
today
1𝑚 𝑈𝑆𝐷
1𝑚 𝑈𝑆𝐷
$1𝑚365
3603.00% = 30,416.67
Maturity Cashflow
1 -1,000,000
2 1,030,417
𝑃𝑉 = 978,205 − 975,310 = 2,895
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FRA example 2
• For example a bank agrees to lend 1m USD
for 1 year starting in 1 year at the fair FRA
rate. The rate is quoted with an ACT/360
daycount basis. At what rate do they lend?
• Assume that the interest rates are as follows:
Maturity Continuously Compounded
Zero Rate
1 2.50%
2 2.60%
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
FRA - example 2
• The cont. comp. forward rate is
𝑓 =2.60% ∙ 2 − 2.50% ∙ 1
2 − 1= 2.70%
• We need to convert this to an ACT/360 rate
𝑒2.70%∙365 365 = 1 + 𝑟365
360
𝒓 = 𝟐. 𝟔𝟗𝟗𝟑%
Maturity Continuously Compounded
Zero Rate
1 2.50%
2 2.60%
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
cc zero PV
2.50% -975,310
2.60% 978,205
Combine the two examples
Maturity Cashflow
1 -1,000,000
2 1,030,417
𝑃𝑉 = 978,205 − 975,310 = 2,895
Remember we computed the PV for example 1
We also worked out the PV of the FRA given the
fair rate. In example 2 we computed the fair rate
(we used the same interest rates intentionally),
plug that fair rate and compute the PV again:
𝑃𝑉 = 𝑁 𝑅𝐾 − 𝑅𝐹 𝐷𝑒−𝑟2𝑇2
= $1𝑚𝑚 ∗ 3.00% − 2.6993%365
360∗ 𝑒−2.6%∗2 = $2,895
Fair rate
𝑟 = 2.6993%
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
“Floating” FRA
• An FRA where one party agrees to pay the
other party whatever market interest rate will
prevail on a date 𝑇1 for the period 𝑇1, 𝑇2
• In other words: “I will pay you the fair interest
for the period 𝑇1, 𝑇2 that will be determined
at (some time 𝑇𝐾 between now and) time 𝑇1”
• What is the PV of this promise?
• Sounds like “I promise to give you what will
be fair at some point in the future”
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
DV01
• Remember that the industry standard for
interest rate risk is the dv01 aka dollar value
of one basis point.
• Looking at the valuation formula
𝑃𝑉 = −𝑁𝑒−𝑟1𝑇1 +𝑁 1 + 𝑅𝐹𝐷 𝑒−𝑟2𝑇2
We can see that there are two interest rates
used in pricing an FRA: 𝑟1 and 𝑟2
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Heuristics
• Assume that 𝑅𝐹 is fixed – the contract has
already been entered.
• If we increase 𝑟1 by a basis point and leave 𝑟2
constant then the lender of money makes
money
• If we increase 𝑟2 by a basis point and leave 𝑟1
constant then the lender of money loses
money
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
More Heuristics
• The alternative valuation formulas are:
𝑅𝐹 =𝑒 𝑟2𝑇2−𝑟1𝑇1 − 1
𝐷
and
𝑃𝑉 = 𝑁 𝑅𝐾 − 𝑅𝐹 𝐷𝑒−𝑟2𝑇2
• If 𝑅𝐹 increases and 𝑟2 stays constant then the
lender loses money.
• If 𝑟2 increases and 𝑅𝐹 stays the same then it
depends on the sign of the PV to being with.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
DERIVING CONTINUOUSLY
COMPOUNDED RATES
Appendix
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Measuring Interest Rates
• The compounding frequency used for an
interest rate is the unit of measurement
• The difference between annual and quarterly
compounding comes that in the latter you
earn interest on interest throughout the year
• All else being equal, a more frequent
compounding frequency results in a higher
value of the investment at maturity
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Impact of Compounding
• When we compound 𝑚 times per year at rate
𝑅, A grows to A(1 + 𝑅/𝑚)𝑚 in one year
Compound. Freq. Value of $100 in 1year at 10%
Annual (m=1) 110.00
Semi-annual (m=2) 110.25
Quarterly (m=4) 110.38
Monthly (m=12) 110.47
Weekly (m=52) 110.51
Daily (m=365) 110.52
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Continuous Compounding
• Frequency of compounding matters
• At the limit of (compounding time)→0
the interest earned grows
exponentially
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
S
xTNxNT /* Let r=rate and
x=compounding time →
Nxrxrxr *1*1*1 Value End
timesN gcompoundin
NxrNexr *1ln
0x0x lim*1lim
How to derive Rc
Substitute
N=T/x
x
xrT
e
*1ln
0xlim
xdx
d
xrTdx
d
e
*1ln
0xlim
rT
rxr
T
ee
1
*1
1
0xlim
Looks like 0/0.
Use de l’Hôpital
Q.E.D.
Make x very
small. Then
use A=eln(A)
Checks: r=0 →End Value=1
T=0 →End Value=1
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Continuous Compounding
• So in the limit as we compound more and
more frequently, we obtain continuously
compounded interest rates
• $100 grows to $100 × 𝑒𝑅𝑐𝑇 when invested at
a continuously compounded rate R for time T
• Conversely, $100 paid at time T has a
PV=$100 × 𝑒−𝑅𝑐𝑇, when the continuously
compounded discount rate is 𝑅𝑐
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
US TREASURY MARKET
Appendix
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Treasury Rates
• Rates on instruments issued by a
government in its own currency
• The rate is different by country and reflects a
combination of credit and economic
considerations
• We will focus only on the US treasury market
Many interesting links, for example: Treasury
http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx
Bloomberg
http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/
Stockcharts
http://stockcharts.com/freecharts/yieldcurve.html
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
US Treasury Market
• There are three primary types of instruments
issued by the US Treasury – T-bills
• Discount instrument issued in 4,13,26 and 52 week
maturities. No Coupons, just a redemption payment.
– T-notes • Coupon instruments issued in 2, 3, 5, 7 and 10 year
maturities
• Pays semi-annual coupons, plus a redemption payment
– T-bonds • Coupon instruments issued in a 30 year maturity
• Pays semi-annual coupons, plus a redemption payment
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
T-bills
• Minimum denomination = $100
• Quoted as a discount rate
• The present value of a T-bill is
𝑃𝑉 = $100 × 1 − 𝑟𝑑𝑎𝑦𝑠
360
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
T-notes and T-bonds
• The difference between notes and
bonds is simply the maturity
– Minimum denomination = $100.
– Pays interest every 6 months.
If the coupon rate is 𝑟 then the interest paid
is 𝑟 2 every 6 months.
– At maturity the notional of the note is paid
to the holder
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Treasury Strips
• Separate Trading of Registered Interest and
Principal of Securities
• STRIPS let investors hold and trade the
individual interest and principal components
of T-notes and T-bonds
• Popular because they let an investor receive
a known payment on a specific future date
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
Treasury Strips
• We will use STRIPs as our instrument of
choice when building a Treasury yield curve – It is quoted as a price. This simplifies the
mathematics
– Frequent maturities.
• These are not as liquid as the underlying
treasury so in practice would not choose to
use these.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR SCANDAL
Appendix
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR Scandal
• No inter-bank lending market – During the financial crisis there was no inter-bank lending
market
– The answer to the daily questions should have been “At
no rate.” or
– Maybe another bank would lend money at an extortionate
rate.
• What would have happened to Barclay’s Bank if the
market found out that they didn’t think they could
borrow money from other banks? Or that they
answered the question with a 50% rate?
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR Scandal
• Manipulation of fixings
– Imagine a 10m USD bet on 3-month USD
LIBOR. If LIBOR>=3.00% then receive 10m
USD. If LIBOR<3.00% then receive nothing.
– What happens if on the morning of the bet
LIBOR is trading at 2.98%? What can a trader
do to win the bet? • Pressure the person making the submission in his
bank to give a higher submission
• Speak to traders at other banks so that they will do
the same.
University of Colorado at Boulder – Leeds School of Business – FNCE-4040 Derivatives
LIBOR Scandal
• June 2012
– Barclay’s Bank paid fines of GBP290m for manipulation of the
rates
– Chairman and CEO resigns
• Dec 2012
– UBS is fined a total of USD1.5bn
• Feb 2013
– Royal Bank of Scotland expecting penalties of USD 612m
• Dec 2013
– 6 financial institutions in Europe fined by European Commission
70-260m EUR.
– UBS avoided fines of 2.5bn EUR by revealing the existence of
cartels.