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    Chapter 1: Interest Rates and Related Contracts

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    Mirelia Kathlin Loayza Tapia
    This document provides an overview of key interest rate concepts: - It defines interest rates and how they are expressed as simple or continuously compounded annual rates. - It discusses LIBOR as a benchmark rate and how rates vary by maturity in the term structure and yield curve. - It introduces the short rate, money market accounts, and zero-coupon bonds (discount bonds) as instruments tied to interest rates. - It explains how zero-coupon bond prices relate to interest rates through the discount curve.

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    Chapter 1: Interest Rates and Related Contracts

    Uploaded by

    Mirelia Kathlin Loayza Tapia
    22 views13 pages
    This document provides an overview of key interest rate concepts: - It defines interest rates and how they are expressed as simple or continuously compounded annual rates. - It discusses LIBOR as a benchmark rate and how rates vary by maturity in the term structure and yield curve. - It introduces the short rate, money market accounts, and zero-coupon bonds (discount bonds) as instruments tied to interest rates. - It explains how zero-coupon bond prices relate to interest rates through the discount curve.

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    This document provides an overview of key interest rate concepts: - It defines interest rates and how they are expressed as simple or continuously compounded annual rates. - It discusses LIBOR as a benchmark rate and how rates vary by maturity in the term structure and yield curve. - It introduces the short rate, money market accounts, and zero-coupon bonds (discount bonds) as instruments tied to interest rates. - It explains how zero-coupon bond prices relate to interest rates through the discount curve.

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

    Chapter 1: Interest Rates and Related Contracts

    Uploaded by

    Mirelia Kathlin Loayza Tapia
    This document provides an overview of key interest rate concepts: - It defines interest rates and how they are expressed as simple or continuously compounded annual rates. - It discusses LIBOR as a benchmark rate and how rates vary by maturity in the term structure and yield curve. - It introduces the short rate, money market accounts, and zero-coupon bonds (discount bonds) as instruments tied to interest rates. - It explains how zero-coupon bond prices relate to interest rates through the discount curve.

    Copyright:

    © All Rights Reserved
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    of 13

    Chapter 1: Interest Rates and Related Contracts

    1.1 Interest Rates and Discount Bonds

    Interest Rate Models


    Damir Filipović
    1.1 Interest Rates and Discount Bonds

    • Various notions of interest rates


    • LIBOR, yield, short rate
    • Money market account
    • Zero-coupon bonds (discount bonds)

    Interest Rate Models


    Interest

    Interest refers to the rent paid by a


    borrower of money to a lender of money
    over a period of time.

    Cash flows for the lender: t T


    • at t: pay a loan of 1 to the borrower
    • at T : receive 1 plus interest R

    Interest Rate Models


    Annualized Interest Rates

    Interest is expressed in annualized interest rates:

    • Simple rate L(t, T ):


    1 + R = 1 + (T − t)L(t, T )
    • Continuously compounded rate (yield) y (t, T ):

    1 + R = e (T −t)y (t,T )

    Interest Rate Models


    Market Example: LIBOR

    LIBOR (London Interbank Offered Rate):


    • Rate at which high-credit financial institutions can borrow on the London
    interbank money market
    • Important reference rate for many interest rate contracts
    • Quoted daily as simple rate L(t, T ) . . .
    • . . . for various maturities (T − t) ranging from 1 day to 1 year
    • . . . for various currencies

    Interest Rate Models


    Term Structure and Yield Curve

    Interest rates depend on lending period


    L(t,T)
    [t, T ]. For varying maturities T we y(t,T)

    obtain the term structure of interest

    Annualized rate
    rates prevailing at t, e.g.

    T 7→ L(t, T ).

    The term structure of yields is also


    called the yield curve T 7→ y (t, T ). Time to maturity T - t

    Interest Rate Models


    Term Structure Dynamics

    For varying dates t we obtain a time


    series of term structures

    (t, T ) 7→ L(t, T ).

    L(t,T)
    Modeling these time series is the aim of
    interest rate models.
    -t
    rity T
    Time t to matu
    Time

    Interest Rate Models


    Short Rate

    Simple calculus shows


    lim L(t, T ) = lim y (t, T ).
    T →t T →t

    This common short end is called short rate r (t).

    It is the rate earned on a loan over the short period [t, t + dt].

    Interest Rate Models


    Money Market Account

    Continuously reinvesting at the short 0.2

    rate gives the money market account 1.3


    0.15

    B(t + dt) = B(t) (1 + r (t) dt) . 1.2

    B(t)

    r(t)
    0.1

    1.1
    With B(0) = 1 this is equivalent to
    0.05
    Rt 1
    r (s) ds
    B(t) = e 0 .
    0
    Time t

    Interest Rate Models


    Zero-Coupon Bonds

    A zero-coupon bond with maturity T is


    a contract that pays its holder 1 at T .
    Also called T -bond.

    Its price at time t is denoted by P(t, T ).

    It is the securitized (tradable) form of a t T


    loan:
    • at t: lender buys a zero-coupon bond
    from and pays P(t, T ) to borrower
    • at T : lender receives 1 from the
    borrower
    Interest Rate Models
    Zero-Coupon Bonds and Interest Rates

    Buying a T -bond at t and holding it until maturity generates a

    • rate of return = simple rate L(t, T ):


    1
    P(t, T ) =
    1 + (T − t)L(t, T )

    • logarithmic rate of return = yield y (t, T ):

    P(t, T ) = e −(T −t)y (t,T )

    Interest Rate Models


    Discount Curve

    A zero-coupon bond is also called a 1

    discount bond: P(t, T ) is the price at


    time t of a cash flow of 1 at maturity T .

    P(t,T)
    For varying maturities T we obtain the
    term structure of zero-coupon bond
    prices prevailing at t, also called the
    discount curve,
    0
    Time to maturity T - t

    T 7→ P(t, T ).

    Interest Rate Models


    Reality Check

    In reality interest rates depend on:


    • creditworthiness of the borrower
    • liquidity needs of lender
    • regulatory requirements
    • market microstructure

    In theory we assume, for this course:


    • no credit risk: P(T , T ) = 1
    • there exists a frictionless market for all T -bonds

    Interest Rate Models

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