FRM Part 1

Financial Markets and

Products

AIM Statement:
www.iplanonline.in Interest rates

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 Products
Financial Markets and
FRM Part 1
AIM Statement:
 Describe Treasury Rates, LIBOR, Repo Rates, and what is meant by the risk-free rate.
 Calculate the value of an investment using daily, weekly, monthly, quarterly, semiannual,
annual, and continuous compounding. Convert rates based on different compounding
frequencies.
 Calculate the theoretical price of a coupon paying bond using spot rates.
 Calculate forward interest rates from a set of spot rates.
 Calculate the value of the cash flows from a forward rate agreement (FRA).
 Describe the limitations of duration and how convexity addresses some of them.
 Calculate the change in a bond’s price given duration, convexity, and a change in interest
rates.
 Describe the major theories of the term structure of interest rates.

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Various Rates

 Treasury rates
 London Inter Bank Offer Rate (LIBOR)
 Repo rates
 Risk free rate
 T-bills and T-bonds; their demand fluctuations and tax treatment
 LIBOR as short term risk free rate
 Overnight Indexed Swap (OIS) rate as risk free rate

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Measuring interest rate and compounding

Annual interest rate = 10%

Interest of an year 
 Annual compounding 10
 Semi-annual compounding 10.25
 Quarterly compounding 10.38
 Monthly compounding 10.47
 Daily compounding 10.5156
 Continuous compounding 10.5171

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Measuring interest rate and compounding

100  110 1 year

• Annual compounding 10%

• Semi-annual compounding 9.7617%
• Quarterly compounding 9.6454%
• Monthly compounding 9.5689%
• Daily compounding 9.5322%
• Continuous compounding 9.5310%

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Zero coupon interest rate

• Also called n period spot rate

• E.g. zero coupon bond with continuous compounding is quoted at 10%
 100 in 1 year will grow to 100 * e0.1 = 110.517

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Bond Pricing

• Sum of the Present values of all cash flows (coupons and the principal)
• The discount rate should be different for different periods
• Spot rates (zero coupon rate)

Example
• What is the price of bond which is paying 6% semi-annual coupon, with 2 years
maturity and $100 face value. ZC rates are given as

Years 0.5 1 1.5 2

Spot rate 4% 4.2% 4.5% 4.6%

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Bond Pricing

r t CF PV
4.00% 0.5 3 2.94
4.20% 1 3 2.88
4.50% 1.5 3 2.80
4.60% 2 3 2.74
4.60% 2 100 91.21

Sum PV 102.57

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Bond yield

• It is a single discount rate that gives the bond’s value equal to market price, when
applied to all cash flows.
• For last example
• PMT = 3, N=4, PV = 102.57, FV =100, CPT I/Y = 2.32% (Semi-annual basis)
• Bond yield = 2.32% * 2 = 4.64%
• When price = par value, the Bond yield = coupon rate; It is called The bond’s par yield

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Bootstrapping spot rates

Principal Time to maturity Annual Coupon Bond Price

(years)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 2.00 8 96.0
Find out spot rate (Zero rate) for 1.5 years.

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Forward rates

Maturity (years) Spot rate (Cont comp)

0.25 10.127%
0.5 10.469%
1 10.536%
1.5 10.681%

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Forward Rate Agreements

• It is an OTC agreement to ensure that certain interest rate will be applied on a

lending or borrowing of
• a certain principal
• during a specified period
• a specific time period away from now.
• Assumption : usually lending or borrowing at LIBOR.

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Forward Rate Agreements

• Party A agrees to lend amount L to party B, through an FRA

• at interest rate RK
• For the time period between T1 and T2. (currently at time 0)
• RM = The actual LIBOR interest rate observed in market at time T1 for the period
between T1 and T2

• Payoff from B to A at time T2 = L * (RK – RM) * (T2 – T1)

• Payoff from B to A at time T1 = L * (RK – RM) * (T2 – T1) / (1+ RM * (T2 – T1) )

• Assumption : compounding at period (T2 – T1)

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Example

• Party A agrees to lend amount $100m to party B, through an FRA, at interest rate of
4% for a period of 3months starting in 3years
• If at the end of 3 years 3 month LIBOR is 4.5%., Find out the payoff.

Solution
100 million * (0.04-0.045) * 0.25 /(1+0.045*00.25)
= - $123,609 (payment at end of 3 years)

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FRA Valuation

• The value of FRA remains 0, as long as RK = RF

• Where, RF = The Forward LIBOR interest rate for the period between T1 and T2,
calculated today

• The value of FRA to A, now = L * (RK – RF) * (T2 – T1) * e (- R2 * T2)

• Where, R2 = continuously compounded riskless Zero rate for the maturity T2.

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Example

• Party A agrees to lend amount $100m to party B, through an FRA, at interest rate of
4% for a period of 3months starting in 3years
• Given, continuously compounded riskless Zero rate for 3.25 years = 4.2%
• If the 3 month LIBOR Forward rate at the end of 3 years is 5%., Find out the payoff.

Solution
100 million * (0.04-0.05) * 0.25 * e (- 0.042 * 3.5)
= - $123,609 (Value of FRA now)

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Duration

• A measure of the time a bond investor needs to wait for cash payments
• A zero coupon bond of n years has the duration =n, but if it has coupon payments
the duration < n
• It captures interest rate risk
• D = - (ΔB / B) / Δ y
• Dollar Duration = D * B
• Modified duration D* = D / (1+y/m)
• Bond Portfolio Duration is weighted average of durations of bonds.

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Convexity

• Duration is useful only for calculation of small changes in interest rates. Since the
relationship is non linear, the second derivative i.e. Convexity is useful.

• (ΔB / B) = - D* Δy + 0.5 * C * (Δy )2

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Term structure of interest rates

• Expectations Theory  Long term interest rates reflect expected future short term
interest rates
• Market Segmentation Theory  Need not be a relationship between Short term
and Long term
• Liquidity preference theory  consistent with empirical finding of upward sloping
yield curve

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Questions
Q1. Which of the following statement about FRA is false -

A) A business which wants to borrow at LIBOR + 50 bps in future, can hedge its position by paying a fixed
interest rate through FRA
B) A bank which wants to lend at LIBOR + 150 bps in future, can hedge its position by receiving a fixed
interest rate through FRA
C) The value of FRA changes with change in forward rates
D) It is an exchange traded instrument.

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Questions
Q2. What is monthly interest equivalent for 9% per annum with continuous compounding?

A) 7.5300%
B) 0.7528%
C) 3.7600%
D) 0.0376%

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Questions
Q3. The 1 year contract rate for 1 year FRA is 6%. If the actual rate is 7% at the time of maturity, what is
the payment to the borrower, if the principal involved is $ 2 million?

A) -10,000
B) 10,000
C) -20,000
D) 20,000

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Questions
Q4. What is 1 year forward rate 6 years from now, if the 7 year spot rate is 5% and 6 year spot rate is
4.5%

A) 4%
B) 8%
C) 6%
D) 9%

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Questions
Q5. A bond with the price of $992 , face value = $1000, 2.5 years to maturity, 3% semiannual coupon is
underpriced/overpriced/ fairly valued?
Given the continuously compounded zero rates are: Z1 = 3%, Z2 = 3.1%, Z3 = 3.2%, Z4 = 3.3%, Z5 = 3.4%

A) Undervalued at value of $994.90

B) Undervalued at value of $989.90
C) Overvalued at value of $989.90
D) Overvalued at value of $994.90

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Thank you

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