Instructor: Beatriz Balbás Aparicio

beatriz.balbas@uah.es
CONTENTS
Fixed income securities and portfolios
Term structure of interest rates
Internal rate of return
Implied forward rates
Price and quotation: Accrued interest
Interest rate risk: Macaulay duration
Net Present Value (NPV)
Interest Rate of Return (IRR)
Fisher intersection
Annuities and mortgages

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FIXED INCOME SECURITIES AND PORTFOLIOS
Every fixed income security will pay known cash flows at known
maturities.
We will denote by , ,…, the set of maturities and by
, ,…, the cash flows.
The security buyer has to pay an initial price at 0.
The security will be represented by

0; ; ; …;
; ; …; 1
;

Or

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 There exists the security face value (also called notional or principal) ,
to be paid at the last maturity.
And a regular coupon which is a percentage of the face value.
FOR INSTANCE…
… A bond whose face value is 1000, whose annual coupon is 5%, and whose
maturity is three years will be represented by

0; 1; 2; 3
2
1012; 50; 50; 1050
Or

Where we are assuming that 1012 is the bond initial price.

Notice that is the unique quantity paid by the asset buyer, since the
remainder are the asset buyer incomes.

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 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 0.
The usual example (but not the unique example) is the Treasury Bill.
FOR INSTANCE…

0; 1,5
, 3
960; 1000

That is a Treasury Bill whose notional is 1000, price 960, and maturity in
"1,5 1,5 12 18 !"# ℎ ".

Combinations of fixed income securities will be called fixed income

portfolios. Maturities and cash flows are still known, so the notation
1 still applies.

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EXAMPLE 1
If we buy Bond % and two units of the zero coupon
bond & , what will be the portfolio?

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EXAMPLE 2
If we buy % and sell two units of & , what portfolio
we will have?

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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
Logarithmic or Continuously Compounded Interest Rates.
PAR-Yield.

Information from the ECB:

http://www.ecb.int/stats/money/yc/html/index.en.html

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Discount Factors. The discount factor '( , associated with the maturity
, may be understood as the amount of money that one must pay
for a zero coupon bond whose face value is €* and whose
maturity is +.

Since the pricing rule must be linear if there are no transaction costs,
the general Portfolio 1 must satisfy

, - . /+. , 6
.1*

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EXAMPLE 3
In particular, for Bond 2 we have

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EXAMPLE 4
The Treasury Bill 3 satisfies

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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 2 2 → 1 4 '( 4 '5 4 0), and they are strictly
lying within the spread 0,1 , except for 0 due to ' 1.

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EXAMPLE 5
Consider the TSIR /* , 67 and /% , 68, and
price a coupon bond whose annual coupon is 1%
and whose face value is €* .

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 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 9+ , which are related to the
discount factors by

1 1
'( ; ( < 1, 8
1: ( ;(
( '(
For 4 0.

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In general, Expression 6 becomes

0
.
- +. . 9
.1* * : 9+.

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EXAMPLE 6
If we take the Bond > from the numerical
example 5, we have the TSIR

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 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
∗
(
∗
@"A 1 : ( ; ( BC < 1. 10
∗ BC∗ → 9 9∗+ < *
( @"A 1 : ( → 1 : ( + D

The relationship between logarithmic rates and discount factors is

EBC∗ ( ∗
@"A '(
'( ; ( , 11
<
EB ∗
( ∗ ∗
@"A '( ∗
F,G /+
'( C → @"A '( <( → <( → 9+ <
+
For 4 0.
Expressions 6 and 9 become
0
∗
- . DE9. +. . 12
.1*
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EXAMPLE 7
; *; %;
If we take Bond > , , we have
; * ; * * ;

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Logarithmic rates are smaller than the equivalent interest rates,
though both values are quite similar for realistic levels.

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Advantages of each type of interest:

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

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 EXAMPLE 8
Suppose that we have a TSIR equal to:

9*/% I%;
9* I%
9% K%
9& K%
9I K%
9K K%
Represent the TSIR with logarithmic interest rates and with discount
factors.

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EXERCISES (I)

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Instructor: Beatriz Balbás Aparicio
beatriz.balbas@uah.es