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Chapter 4 Interest Rate Formulas

1) The document provides formulas for calculating forward prices, future values, interest rates, bond pricing, hedge ratios, and swap valuations. 2) Key concepts include formulas for converting between continuous and compounded rates, calculating optimal hedge ratios, and determining the present value of forward positions and swap cash flows. 3) Several examples are given to illustrate how to apply the formulas, such as calculating future values compounded monthly, determining hedge ratios using correlations between spot and futures prices, and valuing swap payments over time.

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221 views4 pages

Chapter 4 Interest Rate Formulas

1) The document provides formulas for calculating forward prices, future values, interest rates, bond pricing, hedge ratios, and swap valuations. 2) Key concepts include formulas for converting between continuous and compounded rates, calculating optimal hedge ratios, and determining the present value of forward positions and swap cash flows. 3) Several examples are given to illustrate how to apply the formulas, such as calculating future values compounded monthly, determining hedge ratios using correlations between spot and futures prices, and valuing swap payments over time.

Uploaded by

John
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Arbitrage Opportunity

Forward price F3m=S0(1+r)^T

When an investment asset provides a known yield

Fo= So e^(R-Q)T

Chapter 4 interest rate formulas

Future value compounded M times: A(1+(R/M) ^(MN)

Future value Compounded Continuously: Ae^(RN)


𝑚
𝑅𝑚 𝑚𝑁 𝑅𝑚
Rate conversion Continuous rate ( Rc) to compounded by “m” 𝐴𝑒 𝑅𝑐𝑁 = 𝐴(1 + ( 𝑚 ) or (simplified) 𝑒 𝑅𝑐 = (1 + ( 𝑚 ))

𝑅𝑐
𝑅𝑚
𝑅𝑐 = 𝑀𝐿𝑛(1 + ( 𝑚 )) 𝑅𝑚 = 𝑚(𝑒 𝑚 − 1)

Zero rates: 𝐴𝑒 𝑅𝑚𝑁


𝑅2𝑇2−𝑅1𝑇1
Forward rate 𝑇2−𝑇1

Bond Pricing

𝑉 𝑒 −𝑅𝑇 + 𝑉𝑒 −𝑅𝑇 + (𝑉 + 𝐹)𝑒 −𝑅𝑇

V is cash-flow/ dividend payment, R is interest rate/ zero rate, T is time to maturity of payment (example 0.5 and 1 for 6
months and a year), F is Face value of bond.

Par yield
𝐶 −𝑂𝐼𝑆𝑅𝐴𝑇𝐸∗𝑇 𝑐 𝑐
𝑀
𝑒 + 𝑚 𝑒 −𝑂𝐼𝑆𝑅𝐴𝑇𝐸∗𝑇 + (𝐹𝑎𝑐𝑒𝑉𝑎𝑙𝑢𝑒 + 𝑀) 𝑒 −𝑜𝑖𝑠𝑟𝑎𝑡𝑒∗𝑇 =FACE VALUE OF BOND

(𝐵𝑜𝑛𝑑 − 𝐵𝑜𝑛𝑑𝐷)𝑀
𝐶=
𝐴

m is number of coupon payments a year, A is PV of annuity

BOOTSTRAP METHOD
Chapter 3 Formulas
Long hedge

Cost of Asset: S2

Gain on Futures: F2-F1 (F2 is future price at purchase F1 is future price at time hedge is set up S2 is asset price at time
purchased B2 is basis at time of purchase)

Net amount paid: S2-(F2-F1) =F1+b2

Short Hedge

Price of asset: S2

Gain on futures: F1-F2

Net Amount received: S2+ (F1-F2) =F1=b2

Optimal Hedge Ratio


𝜎𝑠
ℎ ∗= 𝜌 (𝜎𝑓) Os is standard deviation of spot price, OF is the standard deviation of futures price p is
coefficient of correlation between Os and OF

Optimal number of contracts


ℎ∗𝑄𝑎
Non adjusted for daily settlement 𝑁𝐹 =
𝑄𝑠

After tailing adjustment to allow for daily settlement of futures NF= H^Va/Vf

Hedging using Index futures


𝑉𝑎
𝛽( ) beta is B Va is the current value of the portfolio Vf is the current value of one future (future
𝑉𝑓
price * contract size)

Changing Beta
(𝛽−𝛽∗)𝑉𝑎
or 𝑁𝑓 ∗ 𝑉𝑓 = −(𝛽𝐹 − 𝛽)𝑃 P= portfolio beta For sell (switch to (B-BF if buy)
𝑉𝑓
Chapter 5 formulas
Present value of s forward position

Nf(Current Forward price –Purchased forward price) 𝑒 −𝑟𝑡

NF is number of forwards

The price of a future with two effective rates and (possible two currencies)
(1+𝑅𝑑)𝑇
𝐹 = (1+𝑅𝑠)^𝑇 (S) S=spot price

The Forward price of an investment

S= Spot price F= future value R= Risk free rate T= Time

𝐹 = 𝑆(1 + 𝑟)𝑇

Forward price with Continuous compounding

𝐹 = 𝑆𝑒 𝑅𝑇

current price of a forward investment

𝐹 = (𝑆 − 𝐼)𝑒 𝑅𝑇

Return on investment with Beta, R and Market Rate

𝑅 + 𝐵𝑒𝑡𝑎 ∗ (𝑀𝑅 − 𝑅)
Chapter 7
Valuation of a swap

Pv of net cash flows

Time (years) Fixed cash flow Floating cash Net cash flow Discount rate Present Value
Is negative flow (positive) of net cashflow

Discount rate is 𝑒 −𝑂𝐼𝑆𝑅𝐴𝑇𝐸∗𝑇

Floating cash flow = LIBOR*Face value*payment Frequency (payment frequency semi annual =0.5 Annual= 1 quarterly=0.25)

Average rate for a period with 2 different rates.


1
𝑅1(𝑅1 − 𝑅2)( )
𝑀2 − 𝑀1

R1 and R2 are continuous rates

M2 and M1 are the durations of each rate (ex; 3 month and 1 month= 3-1)

Value of the payment


𝑅𝑎𝑡𝑒𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛
(𝑃 ∗ 𝑃𝑟𝑖𝑜𝑟 𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 ∗ ( ) − (𝑝 ∗ 𝑓𝑖𝑥𝑒𝑑 𝑟𝑎𝑡𝑒 ∗ ( )) 𝑒 −𝑅𝑇
12 12

Note ** T is time of payment (ex; 3 month swap option with payment every 2 months (payment in (1/12) and (3/12)

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