Interest Rate Derivatives - Forwards and Swaps

Problem Set
Q1. On May 15, 2000 the term structure of interest rates (continuously compounded) is as shown in the
following table.
Maturity T r (0, T )
0.5 6.52%
1 6.71%
1.5 6.79%
2 6.72%
2.5 6.79%
Compute the discount factors Z(0, T), the forward discount factors F(0, T − ∆, T), and the forward rates f
(0, T − ∆, T ), where ∆ = 0.5.
(1) Discount factor: Z(0,T) = e-r(0,T)*(T-t)
Z(0,0.5) = 0.9679 Z(0,1.0) = 0.9351 Z(0,1.5) = 0.9032 Z(0,2.0) = 0.8742 Z(0,2.5) = 0.8434
Z(t,T2)
(2) Forward discount factor: F(t,T1,T2) = e-f(t,T1,T2)(T2-T1) =
Z(t,T1)

F(0,0,0.5) = Z(0,0.5) / Z(0,0) = 0.9679

F(0,0.5,1.0) = 0.9351 / 0.9679 = 0.9661
F(0,1.0,1.5) = 0.9032 / 0.9351 = 0.9659
F(0,1.5,2.0) = 0.8742 / 0.9032 = 0.9679
F(0,2.0,2.5) = 0.8434 / 0.8742 = 0.9648
−ln (F (t,T1,T2))
(3) Forward rate: f (t,T1,T2) =
(T2 − T1)

f(0,0,0.5) = -ln (0.9679) / 0.5 = 0.0653

f(0,0.5,1.0) = -ln(0.9661) / 0.5 = 0.0690
f(0,1.0,1.5) = -ln(0.9659) / 0.5 = 0.0694
f(0,1.5,2.0) = -ln(0.9679) / 0.5 = 0.0653
f(0,2.0,2.5) = -ln(0.9648) / 0.5 = 0.0717

Q2. The following table contains the continuously compounded forward rates F(0, T − ∆, T), where∆ = 0.5.
Note that the first entry is the current spot rate, as for T = 0.5 we have f(0, 0, 0.5) = r(0, 0.5).

Maturity T f (0, T − ∆, T )
0.5 3.58%
1 3.99%
1.5 5.00%
2 5.88%
2.5 4.92%
Compute the forward discount factors F (0, T ∆, T ), the current discount factors Z(0, T ), and the current
term structure of interest rates.
(1) forward discount rate: F(t,T1,T2) = e-f(t,T1,T2)(T2-T1)
F(0,0,0.5) = 0.9823
F(0,0.5,1.0) = 0.9802
F(0,1.0,1.5) = 0.9753
F(0,1.5,2.0) = 0.9710
F(0,2.0,2.5) = 0.9757
(2) Discount factor: Z(0,T) = Z(0,T-1) * F(t,T-1,T)
Z(t,0.5) = 1 * 0.9823 = 0.9823
Z(t,1) = 0.9823 * 0.9802 = 0.9629
Z(t,1.5) =0.9629 * 0.9753 = 0.9391
Z(t,2.0) = 0.9391 * 0.9710 = 0.9119
Z(t,2.5) = 0.9119 * 0.9757 = 0.8897
−ln Z (t,T)
(3) Interest rate: R(t,T) =
(T − t)

R(0,0.5) = -ln(0.9823)/0.5 = 0.0357

R(0,1.0) = -ln(0.9629)/1 = 0.0378
R(0,1.5) = -ln(0.9391)/1.5 = 0.0419
R(0,2.0) = -ln(0.9119)/2 =0.0461
R(0,2.5) = -ln(0.8897)/2.5 =0.0467