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    Tutorial W1 Review of Financial Maths

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    Raj
    The document discusses interest rates and bond pricing. It defines compounding frequency and how it affects interest calculations over time. Higher compounding frequencies result in higher returns. It also covers continuously compounded rates, zero rates, bond pricing using zero rates, and bond yields. The forward rate is defined as the future implied interest rate needed to convert today's term structure to future yields.

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    Tutorial W1 Review of Financial Maths

    Uploaded by

    Raj
    19 views13 pages
    The document discusses interest rates and bond pricing. It defines compounding frequency and how it affects interest calculations over time. Higher compounding frequencies result in higher returns. It also covers continuously compounded rates, zero rates, bond pricing using zero rates, and bond yields. The forward rate is defined as the future implied interest rate needed to convert today's term structure to future yields.

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    The document discusses interest rates and bond pricing. It defines compounding frequency and how it affects interest calculations over time. Higher compounding frequencies result in higher returns. It also covers continuously compounded rates, zero rates, bond pricing using zero rates, and bond yields. The forward rate is defined as the future implied interest rate needed to convert today's term structure to future yields.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    19 views13 pages

    Tutorial W1 Review of Financial Maths

    Uploaded by

    Raj
    The document discusses interest rates and bond pricing. It defines compounding frequency and how it affects interest calculations over time. Higher compounding frequencies result in higher returns. It also covers continuously compounded rates, zero rates, bond pricing using zero rates, and bond yields. The forward rate is defined as the future implied interest rate needed to convert today's term structure to future yields.

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    You are on page 1of 13

    Interest Rates, Compounding

    Frequency, Bond Pricing

    Fundamentals of Futures and Options


    Markets, 7th edition.
    Hull
    Chapter 4

    1
    Measuring Interest Rate

    • 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.

    2
    Compounding Frequency
    of Interest Rate
     For 10% annually compounded, $100 bank
    deposit grows to 100(1+10%)= $110 in one year’s
    time.
     For 10% semi-annually compounded, $100 bank
    deposit grows to 100(1+10%/2)2 = $110.25 in one
    year’s time.
     For 10% quarterly compounded, $100 bank
    deposit grows to 100(1+10%/4)4 = $110.38 in one
    year’s time.

    3
    Compounding Frequency
    of Interest Rate
     The formula is

     FV is future value, PV is present value, Rm is the


    interest rate with compounding m times per year.
     To compute how much you need to put in today to
    get amount FV in future, use

    4
    Continuous Compounding

     In the limit as we compound more and more


    frequently, we obtain continuously compounded
    interest rate.
     $100 grows to $100eR=110.51
     The formula is

     Rc : continuously compounded rate.


     T: number of years.
    5
    Conversion Formula

    Rc : continuously compounded rate.


    Rm: same rate with compounding m times per year.

     Rm 
    R c  m ln  1  
     m 
    Rm  m e Rc / m
    1 
    6
    Zero Rate

    • A zero rate (or spot rate), for maturity T is the


    rate of interest earned on an investment that
    provides a payoff at time T.
    • It is also yield to maturity for a zero coupon bond
    that matures at time T.

    7
    Example

    Maturity Zero Rate


    (years) (% cont. comp.)
    0.5 5.0

    1.0 5.8

    1.5 6.4

    2.0 6.8

    8
    Bond Pricing

     To calculate the theoretical price of a bond we


    discount each cash flow at the appropriate zero
    rate, provided those rates are available.
     Given the zero rates in previous slide, the
    theoretical price of a two-year bond with face value
    of $100 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
    9
    Bond Yield
     The bond yield (yield to maturity), is the discount
    rate that makes the present value of the cash
    flows on bond equal to the market price of bond.
     Suppose the market price of bond equals its
    theoretical price of 98.39.
     The bond yield is given by solving

    y = 0.0676 or 6.76% with cont. comp.


    10
    Which Formula?
     We have 2 formulas to compute bond price.
     The one where we discount by zero rates is a
    pricing formula: given the rates, what is the
    price?
     The one where we discount by bond yield is a
    conversion formula: converting from price to
    yield and vice versa.
     Price, zero rates and yield are inter-connected.

    11
    Forward Rate

     The forward rate is the future zero rate implied by


    today’s term structure of interest rates.
     To illustrate, suppose the 1-year zero rate is 3%
    p.a., 2-year zero rate is 4% p.a, both with cont.
    comp.

    0 1 2
    3%

    12
    4%
    Forward Rate

     The forward rate for year 2 is the interest rate


    that, when combined with the 3% p.a. for year 1,
    gives 4% overall for the 2 years.
     It satisfies the equation
    . 3 . 4
    , R=5%

    0 1 2
    3% R=?

    13
    4%

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