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Part 3. Interest Rates and Interest Rate Related Risks Derivative Instruments Introduction To Mechanisms, Applications and Valuation 1 Term Structure of Interest Rates Bond Valuation Using Average Returns Spot and Forward Rates Valuations with Spot and Forward Rates

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part 3 interest rates and interest rate related risks

Part 3.Interest Rates and Interest Rate Related Risks

Derivative Instruments

Introduction

To Mechanisms,

Applications and Valuation

1

topics covered
Term Structure of Interest Rates

Bond Valuation Using Average Returns

Spot and Forward Rates

Valuations with Spot and Forward Rates

Risk and McCauley Duration

Modified Duration and Convexity

A Different Approach: F.R.A.

Topics Covered
term structure of interest rates
Interest Rate - the interest rate according to the term structureSpot Rate – implied rate to valuate future cash flows

Forward Rate - The interest rate, fixed today for a future period

Current Yield – Coupon payments on a security as a percentage of the security’s market price (gross of accrued interest)

Yield To Maturity (YTM) - The IRR on an interest bearing instrument

YTM (r)

2000 (flat)

2003 (Normal)

1991 (Invers)

Year

1 2 3 4 5 6 7 8 9 10

Term Structure of Interest Rates
term structure theory
What Determines the Shape of the Term Structure ?

1 Unbiased Expectations Theory: Short term rates reflects the current monetary policy of the central bank. In the long range interest rates reflect the future expected short term rates.

Liquidity Premium Theory. Investors tend to prefer short term investments. This is to prevent from being exposed to interest rate related risk. To invest money in the long range, investors ask for higher premiums.

Market Segmentation Theory: There is no linkage between short- medium and long term interest rates. Different groups of investors have different motivations to invest money.

Term Structure (“Theory”)
slide6

Valuing a Bond - Simple Approach

Straight Bond, 5yrs. To Maturity, 5,5 Coupon Rate, annual payment, market rate: 5%

or

+

valuing a bond simple approach
Valuing a Bond - Simple Approach

Semi-annual Coupon Payments:

Example:

n= 10

C= 5,5%

r= 5%

FV= 1000

t= 5

+

Floating Interest Rates (1%/year):

Example:

n= 5

C= 5,5%

r= 5-9%

FV= 1000

t= 5

valuing a bond simple approach8
Valuing a Bond - Simple Approach

Zero Bonds:

Example:

r= 5%

FV= 1000

t= 5

Example:

r= ?

FV= 1000

P= 783.53

t= 5

excursus yield to maturity
All interest bearing instruments are priced to fit the term structure

This is accomplished by modifying the asset price

The modified price creates a New Yield, which fits the Term Structure

The new yield is called the Yield To Maturity (YTM)

Excursus: Yield To Maturity
excursus yield to maturity10
Example

A $1,000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is $ 1,079 what is the YTM ?

Excursus:Yield to Maturity
excurs yield to maturity
Example

A $1,000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 1,079 what is the YTM?

Excurs:Yield to Maturity

C0 C1 C2 C3 C4 C5____

-1079 105 105 105 105 1105

Calculate IRR = 8.5%

excursus yield to maturity12
Excursus:Yield to Maturity

A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is $ 1079 what is the YTM?

valuation spot rates at flat 3 y rates

-

2

×

40.000

1,07

-

3

×

1.040.000

1,07

Valuation - Spot Rates(At Flat 3-y-Rates)

t

t

t

t

0

1

2

3

40.000,00

40.000,00

1.040.000,00

Market Value

-

1

×

40.000

1,07

37.383,18

34.937,55

848.949,79

921.270,52

slide15

t

t

t

t

0

1

2

3

Valuation - Spot RatesDuplicating Cash Flows

40.000,00

40.000,00

1.040.000,00

Market Value ?

971.962,62

-

Loan:

interest 7 %

Interest 7 %

interest 7 %

971962,62

- 68.037,38

- 68.037,38

- 68.037,38

Difference: 0

Difference:

- 28.037,38

+ 26.450,36

Investment:

interest 6 %

interest 6 %

- 26.450,36

+ 1.587,02

+ 1.587,02

Difference: 0

Difference:

- 26.450,36

25.190,82

Investment:

Interest: 5 %

1.259,54

- 25.190,82

Difference: 0

920.321,44

slide16

Valuation Mode

Result (P.V.)

3-y Interest Rate flat (7%)

921.270,52 €

Term – Structure of InterestRates (5,6,7%)

922.644,89 €

Replication of Cash Flows

920.321,44 €

Which is the Right Value ?

Three approaches lead to three results:

But which is the right one ??????

slide17

1

2

3

Yield

5%

6%

7%

Spot Rates

5%

6,03%

7,1%

Proof :

A 3-y-Bond at a 3-y-YTM of 7% will be issued at par, i.e. $ 1,000.

Use Spot Rates to Valuate the Bond

slide18

Example:

Interest Rates (YTM) and Related Spot Rates

slide19

t0

t1

t2

1y Forward Ratelocked in

1y Forward Rate starting in t1

Forward Rates

An interest rate that is not agreed upon a defined period of time starting right now, but for a defined time period, which begins (and ends) in the future, is called a forward rate.

Example: Due to an expected future business development your corporate needs a 1-year loan of 10 Mio €. The loan should be available 1 year from now. You‘d like to fix the future interest rate now.

slide20

Spot Rates and Related Forward Rates(Basic Idea)

You can either borrow now, or fix a rate using a Forward. The rate, that can be locked in today, results from this model: The cost of borrowing now for two years must equal the cost of borrowing now for one year with an obligation to extend the loan for a second year at a „forward rate“ not known now.

Using the spot – rates from the example above and solving the equation for rf,1,1 results in:

interest rate risk

At a market yield of 6.5 % (flat) the two 6.5% coupon bonds are both priced at $ 1,000.

Interest Rate Risk

What does this tell you about the relationship

between bond prices and yields for bonds with

different maturities?

bond premiums and discounts
What happens to bond values if required return is not equal to the coupon rate?

r > Coupon Interest Rate

P0 < par value

DISCOUNT

=

r < Coupon Interest Rate

P0> par value

PREMIUM

=

Bond Premiums and Discounts
  • The bond's price will differ from its par value
slide24

120,00

100

100,00

2%

80,00

78,35

75,13

74,30

67,68

67,29

60,00

56,45

55,68

5%

48,10

40,00

42,41

37,69

10%

31,86

20,00

23,94

14,86

0,00

t 20

t

5

The Duration of A Zerobond Equals it‘s Time to Maturity

slide25

Total Portfolio Value:141,26 €

Value of ReinvestedPayments : 48,84 €

Present Value of FuturePayments : 92,42 €

Interest payments from the bond: 8% / y.Interest rate in the market: 10%

100

+

8

8

8

8

8

8

8

8

8

8

t 10

t 5

t 0

Present Value of future cash flows generated by the bond: 8% / 5y.

Excursus: Calculation of a Portfolio‘s Value

slide28

Modified Duration

In a next step, the Duration can be transformed into the Modified Duration. Technically then the Duration must be divided by the expression (1+r), where r represents the current average market yield.

As a result, MD informs roughly about the changes in portfolio value to be expected when the market yield changes by 1 %. Hereby MD serves as a prognostic tool to check the interest rate sensitivity of each asset or the whole portfolio: An expected interest rate increase of 2.5% will change the Value of an interest bearing portfolio with a Duration of 7.04 relativ to a current market rate of 10% by – 16 %....

slide29

Modified Duration and Convexity

Unfortunately, the MD assumes a linear relation between a bond‘s price and the market yield. As this is not the case, the usage of MD as a tool to forecast value changes must lead to a systematic error, called the „Convexity error“ or the „tracking error“ (see the left figure):

slide30

Locked in Rate: 3,30%

Maturity of F.R.A.

Time to Market

Forward Rates (F.R.A. - Application)

To contract a F.R.A. means to lock in an interest rate concerning a future period. Referring to our term structure, your bank might use an F.R.A. to make sure, that her future costs of financing a 1-year 10 Mio € loan will not exceed 3,30 %.

slide31

Profit

Locked-in Rate: 3,3%

Loss

Forward Rates (F.R.A. - Application)

Scenario 1:Short rate in t1 is at 5%. Financing costs will be 500 T€. Compensations on F.R.A. will be (5%-3,3%)x10 Mio = +170 T€. Total costs at end of year 2: (500-170)=330 T€ (= 3,3%)

Long F.R.A.

Scenario 2:Short rate in t1 is at 2%. Financing costs will be 200 T€. Payments on F.R.A. will be (2%-3,3%)x10 Mio = -130 T€. Total costs at end of year 2: (200 +130)=330 T€ (= 3,3%)

lessons learnt
The Term Structure of Interest Rates Determines Asset Values

To Value Correctly, Spot Rates should be used

Spot and Forward Rates directly result from a given Term Structure of Rates

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The McCauley Duration informs about a point in time, where an asset’s total value is immune against interest rate changes.

Modified Duration and Convexity are used in the context of the McCauley Duration

A Different Approach: F.R.A.bbbbbbbbbö

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Lessons Learnt