FINANCIAL MARKETS AND INSTITUTIONS

TOPIC 2: FIXED-INCOME MARKET

1. Fixed income securities and portfolios
Every fixed income security will pay known cash flows at know n maturities. We will denote by (t1, t2, …,
tm) the set of maturities, and by (c1, c2, …, cm) the cash flows. The security buyer must pay an initial price
c0 at t = 0. The security will be represented by

There exists the security face value (also called notional or principal) N, to be paid at the last maturity. And
a regular coupon c which is a percentage of the face value. Notice that c0 is the unique quantity paid by
the asset buyer, since the remainder ci are the asset buyer incomes.
A particular case of bond is “the zero-coupon bond” or “pure discount bond”. It is characterized by a
unique cash flow equaling the face value. The coupon is c = 0. The usual example (but not the unique
example) is the Treasury Bill.
Combinations of fixed income securities will be called fixed income portfolios. Maturities and cash flows
are still known, so the notation 1 still applies.

2. Term structure of interest rates

The term structure of interest rates (TSIR) applies to price bonds and fixed income portfolios. There exist
several ways to give the TSIR, but we will present only three ones: Discount Factors; Spot Interest Rates;
and Logarithmic or Continuously Compounded Interest Rates.
2.1. Discount factors
The discount factor associated with the maturity t, may be understood as the amount of money
that one must pay for a zero coupon bond whose face value is €1 and whose maturity is t. Since the pricing
rule must be linear if there are no transaction costs, the general Portfolio 1 must satisfy
(6):
The discount factors compose the TSIR of a fixed income market, and they obviously
depend on the market, in the sense that different markets will have different discount factors. For instance,
the German TSIR and the American TSIR will be different in general.
Since time is a negative good (the earlier the better), the discount factors decrease (0 < t < s  1 > ut > us >
0) and they are strictly lying within the spread (0,1), except for t = 0 due to u0 = 1.
2.2. Spot interest rates
The discount factors lead to (6), which is a linear relationship between prices and cash flows, and therefore
a very simple one. But the discount factors are not intuitive enough and, in fact, traders and data providers
only deal with them to estimate the TSIR. In practice, traders prefer something more intuitive and closely
related to “the money price”, or “the profit generated by one Euro in one year”. This is the role of the spot
interest rates rt, which are related to the discount factors by (8):
In general, expression (6) becomes (9):

2.3. Logarithmic interest rates

Interest rates above are very intuitive, but they present several drawbacks in some mathematical
developments. Logarithmic rates will enable us to overcome this caveat, since (9) will become a pure
exponential expression, and therefore it will be easier to represent its derivative and primitive functions.
The logarithmic rate is:

The relationship between logarithmic rates and discount factors is:

Expressions (6) and (9) become (12)

Logarithmic rates are smaller than the equivalent interest rates, though both
values are quite similar for realistic levels.
2.4. Advantages of each type of interest

 Discount factors: it gives a linear formula (without exponents), for the price of bonds.
 Spot interest rates: they are very easily understood by the market.
 Logarithmic interest rates: it simplifies the formulas.

3. Internal rate of return

The TSIR is a function whose independent variable is time, so it is usual to see
quite different interest rates if so, are their associated maturities. In other words,
the TSIR is almost never flat.
In general, the IRR of the bond or portfolio is the solution of the equation,

One can also define the logarithmic (or continuously compounded) Internal Rate of Return (IRR_log), which
is the solution r∗ of the equation,
In general, the IRR is a weighted average of the interest rates affecting the bond or portfolio cash flows.

 If the TSIR is almost flat, then the IRR and the TSIR are very similar.
 If, furthermore, the percentage of the face value giving the bond coupon and the TSIR are very
similar to both.
 Nevertheless, it is worth remarking that these situations are not usual at all.
Thus, there is no analytic solution, and IRR and IRR_log, must be estimated with numerical procedures.

4. Implied forward rates

Consider two future dates 0 < t < s. The implied forward rate rt,s is given by the current TSIR, and
consequently it is a present (not future) interest rate despite the fact that it is connecting future maturities.
Actually, could represent the amount
of money that we might recover at 0 if we invested
1€ at t.

would be the obtained interest rate if right now we were able to replicate the investment with only
two cash flows at t and s. Readers with some notions about derivatives will understand that is the
interest rate of forward or future contracts if they were available in a derivative market.
The implied rate “amplifies” the increasing or decreasing effect of the TSIR. So, when r2 > r1, the increment
of the forward rate r1,2, is higher. If the TSIR were decreasing the fall would be also higher. So, when r2 <
r1, the forward rate, r1,2, is lower.
The discussion above also applies for logarithmic interest rates and logarithmic forward rates, which satisfy,
and are given by

With respect to forward rates, logarithmic forward rates significantly simplify many analytical expressions.
For instance, the latter equality implied: