Lecture 4: Spot Rates, Forward Rates and the

Term Structure

Lecturer: Phạm Thị Hồng Thắm

Foundations of Mathematical Finance

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Table of Contents

1 Spot and Forward Rates of Interest

2 The Term Structure of Interest Rates

3 Calculations with Term Structure

4 Accumulation Function and the Term Structure

5 Interest Rate Swaps

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 Spot and Forward Rates of Interest

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Spot Rates of Interest
Consider an investment at time 0 earning interest from time 0 to t.
We assume that the period of investment is fixed at the time of
investment, but the rate of interest earned per period varies according
to the investment horizon.
We define itS as the spot rate of interest, which is the annualized
effective rate of interest for the period from time 0 to t.
In other words, $1 invested at time 0 accumulates to
 t
a(t) = 1 + itS

at time t.
Or equivalently, the present value of $1 payment at time t is
 −t
v (t) = 1 + itS .

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Forward Rates of Interest

We define itF as the rate of interest applicable to the period [t − 1, t),

called the forward rate of interest.
Note that unlike itS , which applies to a period of length t ([0, t)), itF
applies to a period of length 1 ([t − 1, t)).
Also, this rate is determined at time 0, although the payment is due
at time t − 1.
It is clear that
i1S = i1F .

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Spot and forward rates of interest

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Relationship between and spot rates and forward
rates

Proposition
Assuming the capital market is perfectly competitive then
 n  n−1  
1 + inS S
= 1 + in−1 1 + inF .
 n n 
Y 
1 + inS = 1 + ikF .
k=1

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Example
Suppose the spot rates of interest for investment horizons of 1, 2, 3 and 4
years are, respectively, 4%, 4.5%, 4.5%, and 5%. Calculate the forward
rates of interest for t = 1, 2, 3 and 4.

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Example
Suppose the forward rates of interest for investments in year 1, 2, 3 and 4
are, respectively, 4%, 4.8%, 4.8% and 5.2%. Calculate the spot rates of
interest for t = 1, 2, 3 and 4.

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Multi-period Forward Rates

We have defined forward rates of interest that are applicable over a

period of length 1.
We now define the multi-period forward rate it,τF as the annualized

rate of interest applicable over a period of length τ from time t to

t + τ.

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Proposition

τ 
Y 
F τ F
(1 + it,τ ) = 1 + it+k , if τ is a positive integer,
k=1
 t+τ  t  τ
S
1+ it+τ = 1 + itS F
1 + it,τ .

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Example
Suppose the spot rates of interest for investment horizons of 1, 2, 3 and 4
years are, respectively, 4%, 4.5%, 4.5%, and 5%. Calculate the
F and i F .
multi-period forward rates of interest i1,2 1,3

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 The Term Structure of Interest Rates

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Yield Curve

A plot of spot rates (itS ) against term to maturity (t) is called the
yield curve.
The expression term structure of interest rates refers to the way
interest rates vary with the investment term.

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Common Shapes of Yield Curves

There are four commonly observed shapes of yield curves namely:

Flat: when long term and short term spot rates appear to be the
same.
Upward sloping: when long term spot rates are higher than short
term spot rates.
Downward sloping: when long term spot rates are lower than short
term spot rates.
Inverted humped: when spot rates increases with term then
decreases.

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Flat Yield Curve

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Upward Yield Curve

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Downward Yield Curve

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Inverted Humped Yield Curve

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In normal times, lenders demand higher rates of interest for longer
term loans, and the upward sloping yield curve might be referred to as
a normal yield curve.
In times when current rates are high but lenders anticipate the rates
will drop in the future you might see an inverted yield curve or a flat
yield curve.

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 Calculations with Term Structure

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Example
You are given the following information: i1S = 2.1%, i2F = 2.6%, i3S = 3.1%
and i4F = 3.6%.
a) Calculate the rates of interest i1F , i2S , i3F and i4S .
b) Calculate ä 4 and s̈ 4 .

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Example
You are given the following information about various annuities available in
the market. All the annuities pay $100 at the end of each year over the
period of the investment. It is also given that the spot rate of interest for
1-year maturity is 3%.

Period of investment (in years) Price (in $)

2 190.89
3 281.96
4 369.53

a) Calculate the forward rates of interest itF for t = 2, 3 and 4.

b) You want to accumulate $10,000 after four years by putting a single
payment into a bank account. Based on the information above,
calculate the deposit required.

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Example
Given that

0.04 + 0.002(t − 1) for integral t ≤ 5,
itS =
0.05 for integral t ≥ 6.

a) Find a ∞ .
b) Find itF for t = 1, 2, .., 6.
c) Show that itF = 0.05 for integral t ≥ 7.

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Accumulation Function and the Term Structure

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Accumulation Function and the Term Structure
Recall that a(t) be the accumulated value at time t of $1 invested at
time 0.
Let at (τ ) be the accumulated value at time t + τ of $1 invested at
time t.
It is also referred to as the accumulation function at time t + τ for $1
due at time t.
Then it is easy to see that

a(t + τ )
at (τ ) = .
a(t)

Furthermore, spot rates and forward rates can be calculated by

1
1 + itS = a(t) t ,
1
F
1 + it,τ = at (τ ) τ .

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Example
Suppose a(t) = 0.01t 2 + 0.1t + 1.
a) Compute the spot rates of interest for investments of 1, 2 and 2.5
years.
b) Derive the accumulation function for payments due at time 2,
assuming the payments earn the forward rates of interest.
c) Calculate the forward rates of interest for a payment due at time 2
with time to maturity of 1, 2 and 2.5 years.

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Term Structure and Force of Interest

Proposition
Let δ(t) be the force of interest. Then
 Z t 
S 1
1 + it = exp δ(s)ds ,
t 0
Z t 
F
1 + it = exp δ(s)ds ,
t−1
 Z t+τ 
F 1
1 + it,τ = exp δ(s)ds .
τ t

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Example
Suppose δ(t) = 0.05t.
a) Derive the accumulation function for payments due at time 2,
assuming the payments earn the forward rates of interest.
b) Calculate the forward rates of interest for a payment due at time 2 for
time to maturity of 1 and 2 years.

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 Interest Rate Swaps

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Interest Rate Swaps

An interest rate swap is an agreement between two parties to

exchange cash flows based on interest rate movements in the future.
A simple interest rate swap arrangement involves two companies.
Company A agrees to pay cash flows to Company B equal to the
amount of interest at a pre-fixed rate on a notional principal amount
for a number of years.
At the same time, Company B consents to pay interests to Company
A at a floating rate on the same notional principal for the same
period of time.

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Common Features of an Interest Rate Swap

Swap Term (or Swap Tenor): The contract period of the interest
rate swap. It may be as short as a few months, or as long as 30 years.
Settlement Dates: The specified dates that two counter-parties have
to exchange interest payments.
Settlement Period: The time between settlement dates is called the
settlement period. The settlement period specifies the frequency of
interest payments. It can be annually, quarterly, monthly, or at any
other interval determined by the parties.

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Common Features of an Interest Rate Swap

Notional Amount: The notional principal amount is the

predetermined dollar amount on which the exchanged interest
payments are based. Note that the principal amount is only used for
the calculation of interest payments and is never exchanged.
An accreting swap has the scheduled notional amount increasing
over time, while an amortizing swap has the notional amount
declining over time.
Swap Rate: The fixed interest rate specified in the interest rate swap
contract.
Floating Interest Rate: This is the reference rate for calculating the
floating interest payment at each settlement date. Commonly used
floating reference interest rates in a swap agreement include: Treasury
Bill Rate, Prime Rate, Federal Funds Rate in the US market, and the
LIBOR (London Interbank Offer Rate) in the international markets.

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An Example of Interest Rate Swap
Interest rate swaps can be used to convert a floating rate loan to a
fixed rate debt or vice versa.
Suppose Company A has arranged to borrow $10 million for five years.
The amount of interest is payable at the end of each settlement year
according to the 12-month US dollar LIBOR at the beginning of the
settlement period.
Company A, however, would like to transform this floating rate loan
to a fixed one.
On the other hand, Company B has arranged to borrow $10 million at
a fixed rate of 5% per annum for five years, but would prefer to
convert this fixed rate loan to a floating rate loan.
For this purpose, Company A and Company B may enter into a
simple interest rate swap agreement, with Company A being the
fixed-rate payer and Company B being the floating-rate payer.

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Suppose the 12-month LIBOR after one year is 4.75%. According to
the swap agreement, Company B has to pay

$10, 000, 000 × 4.75% = $475, 000

to Company A at the end of the second year, while Company A needs

to pay
$10, 000, 000 × 5% = $500, 000
to Company B at the same time.
In order to avoid unnecessary transactions, most swap contracts
require both parties to settle the netted amount only.
In this example, the interest rate swap net payment in that settlement
date is $25,000, payable from Company A to Company B.
The fixed interest rate in the interest rate swap contract is called the
swap rate, which will be denoted by RS .

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Determination of the Swap Rate

Consider a n-year interest rate swap contract with notional amount

mt for year t = 1, ..., n.
The settlement period is one year.
At time 0, when the contract is initiated, the spot rates of interest itS
are known.
The floating interest rate is defined as the realized one-year spot
rate it∗ observed at the beginning of the t th future settlement period.
It is obvious that i1∗ = i1S .
Suppose company A has to pay the loan at floating rates it∗ at time
t = 1, 2, .., n but now wants to pay at a fixed rate RS . How do we
determine RS so that the swap contract is equally attractive to both
parties ?

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The present value of the cash flows payable by company A at fixed
rate RS
n
X mt RS
.
t=1
(1 + itS )t
The present value of the cash flows payable by company A at floating
rates
n
X mt it∗
.
t=1
(1 + itS )t
However, at the time when the interest rate swap contract is written,
the floating rates it∗ are not known. We can only hedge them by using
the forward rates itF . Therefore, the present value of the cash flows
payable by company A at forward rates is
n
X mt itF
.
t=1
(1 + itS )t

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To make the swap contract equally attractive to both parties, the
present values payable by company A must be the same using either
the floating rates or the fixed rate. Therefore,
n n
X mt itF X mt RS
= .
t=1
(1 + itS )t t=1
(1 + itS )t

As a result, the swap rate RS can be determined as

Pn mt itF
t=1 (1+itS )t
RS = Pn mt .
t=1 (1+itS )t

If the notional principals are level, i.e. mt does not depend on t, then
Pn itF
t=1 (1+itS )t
RS = Pn 1
.
t=1 (1+itS )t

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Example
A company enters into a 5-year interest rate swap contract with a level
notional amount of $1 million. The settlement period is one year. The
floating interest rate is defined as the realized one-year spot rate observed
at the beginning of each settlement period. The spot rates of interest at
the initiation of the swap for investment horizons of 1, 2, 3, 4 and 5 years
are, respectively, 3.5%, 3.8%, 4.3%, 4.9% and 5.2%. Determine the swap
rate.

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Example
Consider a 5-year interest rate swap contract with the notional amounts $1
million, $2 million,..., and $5 million for t = 1, 2, 3, 4 and 5 respectively.
The spot rates of interest at the initiation of the swap for investment
horizons of 1, 2, 3, 4 and 5 years are, respectively, 3.5%, 3.8%, 4.3%,
4.9% and 5.2%. Determine the swap rate of this swap.

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Market Value of a Interest Rate Swap

A party who enters into an interest rate swap contract can close its
outstanding position by selling or terminating the swap for a price at
any time during the swap term.
This price is called the market value of the swap.
Under the perfect and frictionless market assumption, the market
value of the swap is the present value of the remaining expected cash
flows specified in the contract computed using the prevailing spot
rates of interest at the time of the swap termination.

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The market value may be positive or negative.
A negative swap market value means that the outstanding swap is not
competitive under the current yield curve condition and the seller
would need to compensate the buyer (or the counterparty) to take
over its position.
The market values of the swap with respect to both counterparties
have the same absolute value but opposite signs.

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Example
A company enters into a 5-year interest rate swap contract with a level
notional amount of $1 million. The settlement period is one year. The spot
rates of interest at the initiation of the swap for investment horizons of 1,
2, 3, 4 and 5 years are, respectively, 3.5%, 3.8%, 4.3%, 4.9% and 5.2%.
We have determined that the swap rate is 5.1145%.
Suppose the floating-rate payer would like to sell the contract at the
beginning of the fourth year to a third party and close its position. The
prevailing spot rates of interest at that time for investment horizons of 1
and 2 years are, respectively, 4.5% and 4.7%. Determine the market value
of the swap with respect to the seller.

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Homework

Textbook questions:
Chapter 3: 1,2,3,4,8,11,12,14,15,16,18,20,21.

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