Yield Curves

Philip Symes
Yield Definition
Interest rate (IR) derivatives yield curve
Risks: operational risk, credit risk and market risk (FX risk, IR risk)
Splining: maths v market (can you hedge it)
!iscount "actor time de"inition:

+
=
#$%
&
&
n
I
d
'here I is the interest rate and n is
the num(er o" days
Redemption at par: (ond 'ith "ace value )&%% (ought at )*$ 'ith & year redemption has
yield + , - &
*$
&%%
= = r
Short term in"lation
.ompanies not rated (etter than their national government
Bond prices:
.lean no accumulated interest
!irty price takes account o" interest payment
/g )&%% (ond 0 1+ has )&%% clean price a"ter $ months, (ut )&%- dirty price
.urrent yield:
P
C
r
c
= (. is coupon (+ rate) and P is clean price) ignore time value o"
money
2ield to maturity (234) and internal rate o" return (IRR) present value o" cash"lo's,
yield as a "unction o" price
5here dirty price
f n f f
r
C
r
C
r
C
fC P D
+ +
+
+
+ +
+
+
+
= + =
) & (
&%%

) & ( ) & (
&
and r is annuali6ed
yield
2ield composed o" coupon, principal and compound interest (ie coupon level, maturity
and re7investment rate)
Reinvestment risk assumes payments can (e reinvested at the same rate
8ero coupon (onds have no reinvestment risk par yield curve
9eed smooth yield curve "unction to price securities: regression, "its, splining, etc
:ther non7linear "actors: ta;, re7investment risk (di""erent "or non7generic (onds), price
volatility
<S 3reasury riskless 6ero coupon curve
=ills: 6ero coupon, >& month
9otes: semi7annual, >$m7,y
=onds: semi7annual, ,7&%%y
Par yield curve is "lat
/g )&%% # yr par (ond yield o" ?+: sum o" all cash"lo's discounted at ?+@)&%%
Interest Rate Swaps (IRS)
9otional principal amount (9PA) not e;changed Bust used as re"erence
S'ap "i;ing date is CI=:R , days (e"ore payout
Reset "reDuency o" payment
3enor period o" agreement
=asis day count convention
Payment datesE"reDuencies can (e di""erent on each side o" the s'ap 5orkout interest
rate (predict CI=:R) "rom 6ero coupon products
For hedging: s'ap @ (ond F FR9
Forward Rate Agreements (FRA)
Cike a & period s'ap, (ut paid early
Payments netted and discounted
/g i" you have $4 &,4 CI=:R e;posure, can agree settlement no': compare CI=:R
and FRA at &,m, discount to $m then discount to no'
Settlement
( )

=
#$%
%G# % &
#$%
%$& % %G# %
d
d
N
S
i" $7&,m FRA is $&+ and CI=:R is G#+ at $m
alue At Ris! (aR)
4a; loss that a port"olio can make over &% days (=asel,) 'ithin a certain pro(a(ility
(eg *G+ or &$- sigma)
Helps to evaluate port"olios (risk v return) and give (etter in"ormation on per"ormance
and on implementing diversi"ication strategies
4ost (ased on normal distri(ution: e;pected value and volatility 3his can (e used "or
comparing di""erent time scales (daysE'eeks) and sigmas
Ris! " Return of #wo Asset $ortfolio
!iversi"ication lo'ers risk to port"olio
Co' geared companies ("inanced mainly through eDuity) tend to have lo' pro"it
"luctuations (lo' vol @ sd)
.orrelation o" assets (eg in the same trade) increases risk .ovariance
&
) )( (
&

=
n
y y x x
C
n
i
i i
"rom each value, eg annual share return .orrelation coe""
y x
C
c

=
Standard deviation o" 'hole port"olio
, & , & &,
,
, ,
,
& &
, ) ( ) ( w w w w V + + = 'here '
are the 'eights o" each asset and
&,
is the correlation coe""icient (et'een them
%inimising ris!:
&,
@&: select the com(ination o" assets to give the lo'est sigma
&,
@%: satis"y %
,
,
,
, &
,
& &
= + w w to minimi6e the port"olio variance since
& ,
& w w = and there"ore
,
,
,
&
,
,
&

+
= w
&,
@7&: variance o" the port"olio is ( )
,
, & & &
) & ( w w V = and this can (e solved to
(ring 6ero variance
3he .apital Asset Pricing 4odel deals 'ith this in more detail
<se matrices to compute this "or the 'hole port"olio, eg # assets, 'ith vol %#, %- and
%# (matri; &) and correlations as per matri; ,:
4atri; &: Iolatility 4atri;,: .orrelation
Asset & %#, %, % &%, %?, %*
Asset , %, %-, %# %?, &%, %1
Asset # %, %, %# %*, %1, &%
4ultiply, eg (y using mmult in /;cel, (4&J4,)J4&, to get #;# covariance matri;:
Asset & Asset , Asset #
Asset & %%* %%1- %%1&
Asset , %%1- %&$ %%*$
Asset # %%1& %%*$ %%*
3he diagonals are the variances o" each asset and the o""7diagonals are the co7variances
I" the 'eighting o" each asset in the port"olio is %$, %, and %,, then the port"olio
variance is:
4atri; & 4atri; , 4atri; #
Asset & %$, %,, %, %%*, %%1-, %%1& %$
Asset , %%1-, %&$, %%*$ %,
Asset # %%1&, %%*$, %%* %,
!o (4&J4,)J4# to get a &;& matri;: the variance