03) FINA 1303 - Foundations of Interest Rates - Part - 2 - 7 Feb 20 - With Answers

Course Map
Overview
Pricing of
Foundations of
Financial Institutions Financial Regulations
Interest Rates
Assets
Stock Banking
DCF Sell Side Buy Side
Valuation Regulation
Traditional Asset
Basics of Commercial Monetary
Institutional Pricing
Interest Rates Banking Policy
Investors Models
Investment Alternative
Banking Investors
1
© Prof Veronique Lafon-Vinais – All Rights Reserved
FINA 1303
FOUNDATIONS OF INTEREST RATES
Part II
Veronique Lafon-Vinais
CTP
Associate Professor of Business Education - Department of Finance

Overview
Foundations of
Interest Rates
Students will establish an understanding of

DCF 1. Bond Pricing Basics
1. Zero Coupon Bond
Basics of 2. Coupon Bond
Interest Rates 2. Computing interest for short term debt
Foundations of Interest Rates

© Prof Veronique Lafon-Vinais – All Rights Reserved 3
Bond Basics
 A bond is a financial instrument promising to make a series of payments
on specific dates. It is similar to a loan but unlike loans, bonds are
securities (negotiable, transferable financial instruments)
 Bonds are legal contracts between an issuer and the investors (buyers)
that:
– Require the issuer to make payments to the buyer, and
– Specify in great detail all the terms and conditions, including what
happens in case the issuer fails to make a payment (called “event of
default”)
Bond Basics
Bond Basics: Coupon Bond
 The most common type of bond is a coupon bond:

– Issuer is required to make regular payments, called coupon payments.
– The interest the issuer pays, and which is used to calculate the coupons,
is the coupon rate.
– The frequency of the coupon payments is annual or semi-annual (USA).
– The date on which the principal of the bond is repaid is the maturity
date.
– The final payment includes (1) the principal, face value, or par value of
the bond and (2) the final coupon payment.
Bond Basics
Coupon Bond
Script coupon bond as

buyer would receive a
certificate with coupons
attached.
Coupons not yet paid
Bond Basics
Key Formulas: Bond Price
 That formula for fixed cash flows with a residual value on
maturity date is also the general formula that covers many
different cases of DCF calculations but is also the way (for you
for now) to value bonds based on Coupon (C), Principal (P),
Number of Years (n), Yield To Maturity (i):
𝐶 𝐶 𝐶 𝑃
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = + + ⋯+ +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
𝑪.ሾ𝟏−ሺ𝟏+𝒊ሻ−𝒏 ሿ 𝑷
Bond Price = +
𝒊 (𝟏+𝒊)𝒏
Bond Basics
 If P=0 that is our mortgage case (in part I),
 If P=0 and n= AND i > 0, then it is a consol or a perpetual

bond:
𝑪
Bond Price =
𝒊
 If C= 0 it is a Zero-Coupon Bond:
𝑷
Bond Price =
(𝟏+𝒊)𝒏
Bond Basics
Zero Coupon Bonds

Zero-Coupon Bonds
 Zero-coupon bonds
– Only two cash flows
• The bond’s market price at the time of purchase

• The bond’s face value at maturity
𝑷
Bond Price =
(𝟏+𝒊)𝒏
Bond Basics Copyright ©2015 Pearson Education, Inc. All rights reserved.

Zero-Coupon Bonds - Example
 A one-year zero-coupon bond with a $100,000 face value has an initial

price of $96,618.36
– If you purchased this bond and held it to maturity, you would have the
following cash flows:

Zero-Coupon Bonds
 Yield to Maturity of a Zero-Coupon Bond

– The discount rate that sets the present value of the promised bond payments
equal to the current market price of the bond
– This is the same problem as when we solved for the rate of return
– Yield to Maturity of an n-Year Zero-Coupon Bond:
1/ n
 Face Value 
1  YTM n   
 Price 

Example: Yields for Different Maturities
 Suppose the following zero-coupon bonds are trading at the prices shown
below per $100 face value.
 Determine the corresponding yield to maturity (YTM) for each bond.
Maturity 1 year 2 years 3 years 4 years
Price $96.62 $92.45 $87.63 $83.06

 We can use our equation to solve for the YTM of the bonds.
1/ n
 Face Value 
1  YTM n   
 Price 
 The table gives the prices and number of years to maturity.

 We have
YTM1  (100 / 96.62)1/1  1  3.50%

YTM 2  (100 / 92.45)1/ 2  1  4.00%
YTM 3  (100 / 87.63)1/ 3  1  4.50%
YTM 4  (100 / 83.06)1/ 4  1  4.75%

 Solving for the YTM of a zero-coupon bond is the same process we used
to solve for the rate of return.
 Indeed, the YTM is the rate of return of buying the bond.
 NB: we can do it quickly in our calculator, where we solve for i, with n =
tenor (number of periods) PMT is zero (no coupons), FV is $100 (par value)
and PV is the price (with negative cash flow)

Your Turn!
 Suppose the following zero-coupon bonds are trading at the prices shown
below per $100 face value.
 Determine the corresponding yield to maturity for each bond.
Maturity 1 year 2 years 3 years 4 years
Price $98.52 $96.59 $94.23 $91.48

Your Turn (PRS please)
 The YTMs are
– 1 year bond:
• 1.2%
• 1.5%
• 1.7%
– 2 year bond:
• 1.6%
• 1.75%
• 1.8%
– 3 year bond:
• 1.9%
• 2.0%
• 2.5%
– 4 year bond:
• 2.0%
• 2.25%
• 3%
Bond Basics
Solution: Yields for Different Maturities
 We can solve for the YTM of the bonds. The table gives the prices and
number of years to maturity.
 NB: we can do it quickly in our calculator, where we solve for i, with n=
tenor (number of periods) PMT is zero (no coupons), FV is $100 (par value)
and PV is the price (with negative cash flow)

 We have
YTM1  100 98.52   1  1.50%

1
1
YTM 2  100 96.59 

1
2
 1  1.75%
YTM 3  100 94.23
1
3
 1  2.00%
YTM 4  100 91.48 4  1  2.25%
1

 Solving for the YTM of a zero-coupon bond is the same process we used to
solve for the rate of return.
 Indeed, the YTM is the rate of return of buying the bond.

Example: Computing the Price of a Zero-
Coupon Bond
 Given the yield curve below, what is the price of a 5-year “risk-free” zero-
coupon bond with a face value of $100?

Coupon Bond
 We can use the bond’s yield to maturity to compute the bond’s price as
the present value of its face amount, where the discount rate is the bond’s
yield to maturity.
 From the yield curve, the yield to maturity for 5-year “risk-free” zero-
coupon bonds is 5.0%.

Zero-Coupon Yield Curve Consistent with the Bond Prices in
Example

Coupon Bond
 Execute:
𝑷
Bond Price =
(𝟏+𝒊)𝒏
P  100 / (1.05)  78.35 5

Coupon Bond
 We can compute the price of a zero-coupon bond simply by computing
the present value of the face amount using the bond’s yield to maturity.
 Note that the price of the 5-year zero-coupon bond is even lower than the
price of the other zero-coupon bonds in Example 6.1, because the face
amount is the same but we must wait longer to receive it.

Your Turn!
 Given the yield curve below, what is the price of a 3-year risk-free zero-
coupon bond with a face value of $900?

 The price is:
 $900
 $879
 $788.67
Bond Basics
Solution: Computing the Price of a Zero-
Coupon Bond
 We can use the bond’s yield to maturity to compute the bond’s price as
the present value of its face amount, where the discount rate is the bond’s
yield to maturity.
 From the yield curve, the yield to maturity for 3-year risk-free zero-
coupon bonds is 4.50%.

Zero-Coupon Yield Curve Consistent with the Bond Prices in
Example

Solution: Computing the Price of a Zero-
Coupon Bond
Execute:
𝑷
Bond Price =
(𝟏+𝒊)𝒏
P = 900 / (1.045)3 = $788.67

U.S. Government Securities “Treasuries”
Video on Tbills: https:// https://
www.youtube.com/watch?v=aVvDy www.treasury.gov/resource-center/data-chart-
9gVe90 center/quarterly-refunding/Documents/auction
s.pdf
The 30 year
Because of their short tenor, US T-Bond is
T-Bills are zero coupon. They called the
trade at a discount to yield. “long bond”

Zero-Coupon Yield Curve

Coupon Bonds

Coupon Bonds
 Coupon bonds
– Pay face value at maturity
– Also make regular coupon interest payments
 Return on a coupon bond comes from:
• The difference between the purchase price and the

principal value
• Periodic coupon payments
 To compute the yield to maturity of a coupon bond, we need to know the
coupon interest payments, and when they are paid
Bond Pricing Copyright ©2015 Pearson Education, Inc. All rights reserved.

 That formula for fixed cash flows with a residual value on
maturity date is also the general formula that covers many
different cases of DCF calculations but is also the way (for you
for now) to value bonds based on Coupon (C), Principal (P),
Number of Years (n), Yield To Maturity (i):
𝐶 𝐶 𝐶 𝑃
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
𝑪.ሾ𝟏−ሺ𝟏+𝒊ሻ−𝒏 ሿ 𝑷
Bond Price = +
𝒊 (𝟏+𝒊)𝒏
Bond Pricing
Example: Computing the Yield to Maturity of a
Coupon Bond
 Consider a five-year, $1,000 bond with a 2.2% coupon rate and
semiannual coupons .
 If this bond is currently trading for a price of $963.11, what is the bond’s
yield to maturity?

Coupon Bond
 We can solve it by financial calculator, or a spreadsheet. To use a financial
calculator, we enter the price we pay as a negative number for the PV (it is
a cash outflow), the coupon payments as the PMT, and the bond’s par
value as its FV. Finally, we enter the number of coupon payments
remaining (10) as N.
Given: 10 -963.11 11 1,000

Solve for: 1.50
Excel Formula: =RATE(NPER,PMT,PV,FV)=
RATE(10,11,-963.11,1000)

Coupon Bond
 Therefore, y = 1.50%.
 Because the bond pays coupons semiannually, this yield is for a six-month
period.
 We convert it to an APR by multiplying by the number of coupon
payments per year.
 Thus the bond has a yield to maturity equal to a 3.0% APR with
semiannual compounding.

Coupon Bond
 As the equation shows, the yield to maturity is the discount rate that
equates the present value of the bond’s cash flows with its price.
 Note that the YTM is higher than the coupon rate and the price is lower
than the par value.

Example: Computing a Bond Price from Its Yield
to Maturity
 Consider a five-year, $1,000 bond with a 2.2% coupon rate and
semiannual coupons.
 Suppose interest rates drop and the bond’s yield to maturity decreases to
2% (expressed as an APR with semiannual compounding).
 What price is the bond trading for now?

to Maturity
 Given the yield, we can compute the price.
 First, note that a 2.0% APR is equivalent to a semiannual rate of 1.0%.

 Also, recall that the cash flows of this bond are 10 payments of $11, paid
every 6 months, and one lump-sum cash flow of $1,000 (the face value),
paid in 5 years (ten 6-month periods).
 We can compute the effective annual yield from the bond’s yield to
maturity expressed as an APR.

to Maturity
 We can use a financial calculator:
Given: 10 1.0 11 1,000

Solve for: -1,009.47
Excel Formula: = PV(RATE,NPER,PMT,FV)=PV(.01,10,11,1000)

Your Turn!
 Consider a nine-year, $1,000 note with a 3% coupon rate and semiannual

coupons.
 If this bond is currently trading for a price of $1,038.32, what is the bond’s
yield to maturity?

 The bond’s YTM (on an APR basis) will be:
 1.26%
 2.52%
 3.16%
Bond Pricing
Solution: Computing the Yield to Maturity of a
Coupon Bond
 From the cash flow timeline, we can see that the bond consists of 18
payments of $15, paid every 6 months, and one lump-sum payment of
$1,000 in 9 years (eighteen 6-month periods).
 We can solve for the yield to maturity.
 However, we must use 6-month intervals consistently.

Coupon Bond
 We can solve it by financial calculator, or a spreadsheet. To use a financial
calculator, we enter the price we pay as a negative number for the PV (it is
a cash outflow), the coupon payments as the PMT, and the bond’s par
value as its FV. Finally, we enter the number of coupon payments
remaining (10) as N.
Given: 18 -1038.32 15 1,000

Solve for: 1.26
Excel Formula: =RATE(NPER,PMT,PV,FV)=
RATE(18,15,-1038.32,1000)

Coupon Bond
 Therefore, y = 1.26%.
 Because the bond pays coupons semiannually, this yield is for a six-month
period.
 We convert it to an APR by multiplying by the number of coupon payments
per year.
 Thus the bond has a yield to maturity equal to a 2.52% APR with semiannual
compounding.
 As the equation shows, the yield to maturity is the discount rate that
equates the present value of the bond’s cash flows with its price.

Bond Pricing Recap

Bond Pricing
 The relationship between the bond price and interest rates is

very important.
– Bonds promise fixed payments on future dates, so the higher the
interest rate, the lower their present value.
 The value of a bond varies inversely with the interest rate

used to calculate the present value of the promised payment.
Bond Pricing
Bond Pricing Example
 Bond terms and conditions:
 Par Value / Face Value: US$1000
 Coupon Rate: 3.15%
 Coupon Frequency: Annual
 Tenor: 7 years
 Else: N/A
 Key terms for calculations:

 Annual Coupon Amount (PMT): US$1000 x 3.15% = US$31.50
 Principal Payment (FV): US$1000
 Nbr Payments (NPER): 7
Bond Pricing
Bond Pricing Example
 Then depending on what is available, Bond Price (PV) or interest
rate, Yield To Maturity “YTM” (i) it’s possible to calculate the other:
$31.5 $31.5 $31.5 $1000
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 1 + 2 + ⋯+ 7 +
(1+𝑖) (1+𝑖) (1+𝑖) (1+𝑖)7
 If YTM = i = 2%,
$31.5 $31.5 $31.5 $1000
(1 + 2%)1 (1 + 2%)2 (1 + 2%)7 (1 + 2%)7
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = $1074.43 = 107.44% × 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
 If YTM = i = 4%,
$31.5 $31.5 $31.5 $1000
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = + + ⋯ + +
(1 + 4%)1 (1 + 4%)2 (1 + 4%)7 (1 + 4%)7
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = $948.98 = 94.90% × 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
Bond Pricing
Bond Pricing
 Generally bonds prices are expressed in % of the Par Value / Face Value, so for a
3.15% annual coupon bond, we can observe how the bond price changes as a
function of a) the YTM and b) the tenor
Bond price as a funtion of the YTM and the tenor:
Tenor / YTM 0.00% 1.00% 2.00% 3.00% 3.15% 3.50% 4.00% 5.00% 6.00%
1 103.15% 102.13% 101.13% 100.15% 100.00% 99.66% 99.18% 98.24% 97.31%
2 106.30% 104.24% 102.23% 100.29% 100.00% 99.34% 98.40% 96.56% 94.77%
3 109.45% 106.32% 103.32% 100.42% 100.00% 99.02% 97.64% 94.96% 92.38%
4 112.60% 108.39% 104.38% 100.56% 100.00% 98.71% 96.91% 93.44% 90.12%
5 115.75% 110.43% 105.42% 100.69% 100.00% 98.42% 96.22% 91.99% 87.99%
6 118.90% 112.46% 106.44% 100.81% 100.00% 98.14% 95.54% 90.61% 85.99%
7 122.05% 114.47% 107.44% 100.93% 100.00% 97.86% 94.90% 89.30% 84.09%
8 125.20% 116.45% 108.42% 101.05% 100.00% 97.59% 94.28% 88.04% 82.30%
9 128.35% 118.42% 109.39% 101.17% 100.00% 97.34% 93.68% 86.85% 80.62%
10 131.50% 120.36% 110.33% 101.28% 100.00% 97.09% 93.11% 85.71% 79.02%
11 134.65% 122.29% 111.25% 101.39% 100.00% 96.85% 92.55% 84.63% 77.52%
12 137.80% 124.20% 112.16% 101.49% 100.00% 96.62% 92.02% 83.60% 76.11%
13 140.95% 126.09% 113.05% 101.60% 100.00% 96.39% 91.51% 82.62% 74.77%
14 144.10% 127.96% 113.92% 101.69% 100.00% 96.18% 91.02% 81.69% 73.51%
15 147.25% 129.81% 114.78% 101.79% 100.00% 95.97% 90.55% 80.80% 72.32%
20 163.00% 138.80% 118.80% 102.23% 100.00% 95.03% 88.45% 76.94% 67.31%
25 178.75% 147.35% 122.45% 102.61% 100.00% 94.23% 86.72% 73.93% 63.57%
30 194.50% 155.49% 125.76% 102.94% 100.00% 93.56% 85.30% 71.56% 60.77%
Bond Pricing
Bond Pricing
Bond Price (YTM, Tenor)
200%
180%
160%
140%
120%
100% Bond Price
80%
60%
40%
20%
10%
4
7
10
13
16
19
Tenor (years)
22
25
28
YTM
Bond Pricing
Bond Pricing
 The main observations from that chart are:
 If YTM is equal to Coupon Rate then Bond Price = 100% of Par Value
 If YTM is higher than Coupon Rate then Bond Price < 100% of Par
Value
 If YTM is lower than Coupon Rate then Bond Price > 100% of Par Value
 The Tenor further amplifies those variations
Bond Pricing
Bond Pricing
 Don’t forget …”extreme” cases…just in case we face one or
the other, with large variations:
Tenor/YTM -10.00% -5.00% -1.00% 0.00% 3.15% 10.00% 20.00% 50.00%
1 114.61% 108.58% 104.19% 103.15% 100.00% 93.77% 85.96% 68.77%
2 130.85% 117.61% 108.43% 106.30% 100.00% 88.11% 74.26% 47.94%
3 148.88% 127.12% 112.70% 109.45% 100.00% 82.97% 64.51% 34.06%
4 168.93% 137.12% 117.02% 112.60% 100.00% 78.29% 56.38% 24.81%
5 191.20% 147.65% 121.39% 115.75% 100.00% 74.03% 49.61% 18.64%
6 215.94% 158.74% 125.80% 118.90% 100.00% 70.17% 43.97% 14.53%
7 243.43% 170.41% 130.25% 122.05% 100.00% 66.65% 39.26% 11.78%
8 273.98% 182.70% 134.75% 125.20% 100.00% 63.46% 35.34% 9.96%
9 307.92% 195.63% 139.29% 128.35% 100.00% 60.55% 32.08% 8.74%
10 345.64% 209.24% 143.88% 131.50% 100.00% 57.91% 29.36% 7.92%
15 387.54% 223.57% 148.51% 134.65% 100.00% 55.51% 27.09% 7.38%
20 434.10% 238.65% 153.19% 137.80% 100.00% 53.33% 25.20% 7.02%
25 485.84% 254.53% 157.92% 140.95% 100.00% 51.34% 23.62% 6.78%
30 543.32% 271.24% 162.70% 144.10% 100.00% 49.54% 22.31% 6.62%
50 607.19% 288.83% 167.53% 147.25% 100.00% 47.90% 21.22% 6.51%
100 678.15% 307.35% 172.40% 150.40% 100.00% 46.41% 20.31% 6.44%
Bond Pricing
Interest for short term debt instruments

Money Market ( 1 Year) Rates
 For debt instruments within a year, interest calculations as
well as names are different!
 Money market instruments include: Time Deposits, T Bills,
Certificate of Deposits, Commercial Paper, Bankers’
Acceptances, Forward Rate Agreements (FRA) including those
listed in future markets.
 The interest are calculated as follow:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐷𝑎𝑦𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 . 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒.
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑌𝑒𝑎𝑟
MM Rates
Simple Interest on Short Term Loans
Simple interest applied to short term loans:
FV = PV [ 1 + r x (d/y)]
Where
 FV = Future Value
 PV = Present Value
 r = interest rate
 d = number of days to term
 y = year basis used in calculation
Debt instrument types

The DIY Dilemma
 On 1st January 2010, Delta Investments Yield has HK$10 million excess
cash to invest for 2 months; the treasurer considers the following options:
 Placing the money in 2 month fixed deposit in Sunny Bank Ltd that pays
3% on a money market (actual/365) day basis
 Buying a Lucky Gold Company bond with a remaining maturity of 2
months that yields 3% on a bond basis (30/360)
 What should DIY do?
Market conventions
The DIY Dilemma (Continued)
 Ceteris paribus, what is the only difference between the two options?
 What other factors should DIY consider?
 How do we compare the two options?
– Interest calculation: Principal * Interest rate * DTM/year
– Why is that important?
Market conventions
To compare the two options, we need to answer the following questions:

 How do we calculate the number of days to maturity?
 How is the number of days in the year defined?
Market conventions
Day Count Conventions
 Day count convention (year basis) is the market convention used in

calculating interest expressed as a ratio of number of days in a month (d)
to number of days in a year (y)
 Most common conventions:
Actual 30
Actual X
365 X
360 X X
Market conventions
Market Calculation Coupon Structures Coupon Payment Day Count Convention
Convention
Brunei Darussalam N/A N/A N/A N/A
Cambodia N/A N/A N/A N/A
China Yield to Maturity Fixed coupon mostly; two listed float –rate Annual Actual/365
treasury bonds
Hong Kong Yield to Maturity EFBNs are issued on a discount basis EFBNs are issued on a Government: Actual/365
discount basis
Japan Yield to Maturity Fixed coupon; float-rate for 15yr maturities Semi-annual coupon Government:
Actual/Actual
Indonesia Yield to Maturity Fixed and variable coupons for government Quarterly or semi annual Government:
bonds; Variable rate bonds for some depending on the terms Actual/Actual
recapitalization bond issues of the bonds
Korea, Republic of Yield to Maturity All coupon-bearing bonds. Some Municipal Annual or semi-annual Government:
bond (Seoul Sub) issues are deferred Actual/Actual
amortized and some MSB are discounted
Lao PDR N/A Fixed Annual N/A
Malaysia Yield to Maturity; Fixed for government bonds Annual or semi-annual Government:
Internal rate of return Actual/Actual
of cash flows Corporate: Actual/365
Myanmar N/A Fixed N/A N/A
Philippines Yield to Maturity FXTNs/RTBs, fixed coupon; T-bills/CMBs, Semi-annual except for Government:
zero coupon RTBs Actual/Actual
Corporate: Actual/365
Singapore Yield to Maturity Varies depending on instrument SGS Bond: Semi-annual SGS Bond: Actual/Actual
coupon
Thailand Yield to Maturity Fixed for government bonds; Floating rate Semi-annual Government: Actual/365
notes are also issued
Vietnam Varies depending on Varies depending on instrument Varies depending on the Varies depending on the
the instrument instrument instrument

Day Count Conventions
Sunny Bank Lucky Gold

 Actual/365  30/360
 Interest calculation:  Interest calculation:
10,000,000*3%*actual number of 10,000,000*3%*(30 days/month
days in 2 months/365 for 2 months)/360
Can we do the calculation?

When does the deposit start and when does it mature?
Market conventions
After the treasurer agrees a trade with the banker, it takes time for the
transaction to be executed: the trade date is generally not the same as the
settlement date
 What do we need to know?
Market conventions
Trade and Value Dates
 When does the DIY Treasurer call his banker?

– The trade date
 When can the money be invested?

– The value/settlement date
 When can the money be returned?

– The maturity date
Market conventions
Trade, Value & Maturity Dates
Trade/ Value/ Maturity/

Fixing Settlement/ Term
Date Effective Date
Date
T V=T+_ M=V+_
Market conventions
Illustration: 1 Month Deposit
Trade Value 1 month Maturity

Date: Date: Date:
28/03 30/03 30/04
T V=T+2 V + 1 month
Market conventions

 Trade date : ?  Trade date : ?
 Value date: (spot) T+ 2 business  Value date: (spot) T+ 2 business
days days
 Maturity date : V+ 2 months  Maturity date : V+ 2 months
But, wait a minute… 1st January is a public holiday!
Market conventions
Business Day Definitions
 1st January 2010 (Friday) is a public holiday in HK => DIY’s treasurer cannot
reach his banker and has to wait for the next banking day to agree a trade
– The next day when banks are open is Monday 4th January, which is the Trade Date
 Let’s assume market convention is spot (T+2) for deposits and bond purchases
– The Value Date will be T + 2 : Wednesday 6th January
 To determine the Maturity Date we need to compute 2 (calendar) months from

the Value Date
– that is to say Saturday 6th March
 But Saturday is not a banking day, what do we do?
Market conventions
Business Day Conventions
 Market convention for adjusting payment dates in response to days that

are not business days
 Definition of “business day”
 Most common business day conventions:
– Following
– Preceding
– Modified following
Market conventions
Business Day Conventions
Trade/ Value/ Maturity/

Fixing Settlement Business Term Business
Date Date Day Date Day
V+_
T T+_
Preceding Following
Modified Following
Market conventions

 Trade date : Monday 4th January  Trade date : Monday 4th January
 Value date: Wednesday 6th  Value date: Wednesday 6th
January January
 Maturity date : (applying  Maturity date : (applying
modified business day): Monday modified business day): Monday
8th March 8th March
Now we can calculate DTM using the relevant convention
Market conventions
DTM applying day count convention

 Day count convention: actual/365  Day count convention: 30/360
 Means we count the actual  Means each month is assumed to
number of days in the relevant have 30 days and the year 360
months and 365 days in a year days
 January = 25 days (31-6) +  January = 24 days (30-6)+
February 28 days + March 8 days February 30 days+ March 8 days
 DTM = 61 days  DTM = 62 days
Market conventions
The DIY Dilemma Solution
 Trade date : 4 January 2010  Trade date : 4 January 2010
 Value date: 6 January  Value date: 6 January
 Maturity date : 8 March  Maturity date : 8 March
 DTM = 61  DTM = 62
 Interest:=  Interest = 10,000,000*3%*62/360
10,000,000*3%*61/365 = = 51,666.67
50,136.99
Ceteris paribus, DIY should invest in Lucky Gold bond
Market conventions
Your turn! Supreme Bank
 Trade date: Friday 29 January 2010

 Supreme Bank (HK) Ltd borrows HK$ 50 million for 1 month from KS Lee
Bankers (HK) Co at 5 % p.a.
 What amount of interest will Supreme Bank pay?
Market conventions
Supreme Bank: What Do We Need to Know?
 What is the market convention for value date?

– Deposits: spot (T + 2)
 What is the day count convention?

– Actual/365
 What is the business day definition?

– Banking days in HK
– Modified Following applies to maturity date
Market conventions
Supreme Bank Solution Steps
 First calculate the Value Date

– V=T+2
– V=
 Then determine the Maturity Date

– M = V + (calendar) month adjusted by the business day convention
– M=
 Calculate DTM
– DTM =
 Calculate interest applying day count convention

– Interest =
Market conventions
Supreme Bank solution
 Trade date: 29 January (Friday)

 Value date: 2 February (Tuesday)
 Maturity date: 2 March (Tuesday)
 DTM: 28
 Convention: actual/365
 Interest: 191,780.82
Market conventions
Annex
Footer TBD
Basic Math Refresher
 Macaulay Duration
𝐶 𝐶 𝐶 𝑃
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = + + ⋯ + +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
𝑑𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 −𝐶 −2𝐶 −𝑛𝐶 −𝑛𝑃
= + + ⋯+ +
𝑑𝑖 (1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)𝑛 +1 (1 + 𝑖)𝑛+1
−(1 + 𝑖). 𝑑𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
𝑑𝑖
𝐶 2. 𝐶 𝑛. 𝐶 𝑛. 𝑃
= + + ⋯+ +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛 (1 + 𝑖)𝑛
𝑘=𝑛
−(1 + 𝑖). 𝑑𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 𝑘. 𝐶 𝑛. 𝑃
=෍ 𝑘
+
𝑑𝑖 (1 + 𝑖) (1 + 𝑖)𝑛
𝑘=1
Footer TBD
 We define a Zero Coupon bond as such:
𝑃
𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 =
(1 + 𝑖)𝐷
𝑑𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 −𝐷. 𝑃
=
𝑑𝑖 (1 + 𝑖)𝐷+1
−(1 + 𝑖). 𝑑𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 𝐷. 𝑃
=
𝑑𝑖 (1 + 𝑖)𝐷
−(1 + 𝑖). 𝑑𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒
= 𝐷. 𝑍𝑒𝑟𝑜 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑟𝑖𝑐𝑒
𝑑𝑖
 If that Zero Coupon bond is to be a first order proxy to coupon
bond, then:
Footer TBD
D has to be defined as:
𝑘. 𝐶 𝑛. 𝑃
σ 𝑘=𝑛 +
(1 + 𝑖)𝑘 (1 + 𝑖)𝑛
𝑘=1
𝐷=
𝐶 𝑃
σ 𝑘=𝑛 +
𝑘=1 (1 + 𝑖)𝑘 (1 + 𝑖)𝑛
D being the Weighted Average Maturity of The Cash Flows of the
coupon bond; it is the Macaulay Duration!
So:
−(1 + 𝑖). 𝑑𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
= 𝐷. 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
𝑑𝑖
𝑑𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 1 −𝐷
. =𝐷
𝑑𝑖 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 1+𝑖
Footer TBD
 So we can therefore calculate the impact of a small variation
of interest rate on the price of the coupon bond:
∆𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 −𝐷. ∆𝑖
=
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 1+𝑖
 Which is:
−𝐷. ∆𝑖
∆𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = . 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
1+𝑖
Footer TBD

03) FINA 1303 - Foundations of Interest Rates - Part - 2 - 7 Feb 20 - With Answers

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03) FINA 1303 - Foundations of Interest Rates - Part - 2 - 7 Feb 20 - With Answers

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Course Map

© Prof Veronique Lafon-Vinais – All Rights Reserved

Students will establish an understanding of

Foundations of Interest Rates

 The most common type of bond is a coupon bond:

Script coupon bond as

Coupons not yet paid

 If P=0 and n= AND i > 0, then it is a consol or a perpetual

© Prof Veronique Lafon-Vinais – All Rights Reserved 9

• The bond’s market price at the time of purchase

© Prof Veronique Lafon-Vinais – All Rights Reserved

 A one-year zero-coupon bond with a $100,000 face value has an initial

© Prof Veronique Lafon-Vinais – All Rights Reserved 11

 Yield to Maturity of a Zero-Coupon Bond

– Yield to Maturity of an n-Year Zero-Coupon Bond:

© Prof Veronique Lafon-Vinais – All Rights Reserved 12

Maturity 1 year 2 years 3 years 4 years

Price $96.62 $92.45 $87.63 $83.06

© Prof Veronique Lafon-Vinais – All Rights Reserved 13

© Prof Veronique Lafon-Vinais – All Rights Reserved 14

YTM1  (100 / 96.62)1/1  1  3.50%

© Prof Veronique Lafon-Vinais – All Rights Reserved 15

© Prof Veronique Lafon-Vinais – All Rights Reserved 16

Maturity 1 year 2 years 3 years 4 years

Price $98.52 $96.59 $94.23 $91.48

© Prof Veronique Lafon-Vinais – All Rights Reserved 17

© Prof Veronique Lafon-Vinais – All Rights Reserved 19

YTM1  100 98.52   1  1.50%

YTM 2  100 96.59 

© Prof Veronique Lafon-Vinais – All Rights Reserved 20

© Prof Veronique Lafon-Vinais – All Rights Reserved 21

© Prof Veronique Lafon-Vinais – All Rights Reserved 22

© Prof Veronique Lafon-Vinais – All Rights Reserved 23

© Prof Veronique Lafon-Vinais – All Rights Reserved 24

P  100 / (1.05)  78.35 5

© Prof Veronique Lafon-Vinais – All Rights Reserved 25

© Prof Veronique Lafon-Vinais – All Rights Reserved 26

© Prof Veronique Lafon-Vinais – All Rights Reserved 27

 The price is:

© Prof Veronique Lafon-Vinais – All Rights Reserved 29

© Prof Veronique Lafon-Vinais – All Rights Reserved 30

P = 900 / (1.045)3 = $788.67

© Prof Veronique Lafon-Vinais – All Rights Reserved 31

© Prof Veronique Lafon-Vinais – All Rights Reserved 32

© Prof Veronique Lafon-Vinais – All Rights Reserved 33

© Prof Veronique Lafon-Vinais – All Rights Reserved 34

 Return on a coupon bond comes from:

• The difference between the purchase price and the

© Prof Veronique Lafon-Vinais – All Rights Reserved 35

© Prof Veronique Lafon-Vinais – All Rights Reserved 37

Given: 10 -963.11 11 1,000

© Prof Veronique Lafon-Vinais – All Rights Reserved 38

© Prof Veronique Lafon-Vinais – All Rights Reserved 39

© Prof Veronique Lafon-Vinais – All Rights Reserved 40

© Prof Veronique Lafon-Vinais – All Rights Reserved 41

 First, note that a 2.0% APR is equivalent to a semiannual rate of 1.0%.

© Prof Veronique Lafon-Vinais – All Rights Reserved 42

Given: 10 1.0 11 1,000

© Prof Veronique Lafon-Vinais – All Rights Reserved 43

 Consider a nine-year, $1,000 note with a 3% coupon rate and semiannual

© Prof Veronique Lafon-Vinais – All Rights Reserved 44

 The bond’s YTM (on an APR basis) will be:

© Prof Veronique Lafon-Vinais – All Rights Reserved 46