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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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.

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In general, the IRR of the bond or portfolio
0; ; ; …;
; ; ; …; is the solution of the equation

. 13
1

One can also define the logarithmic (or continuously

compounded) Internal Rate of Return ( _ ),
which is the solution ∗ of the equation
∗
, 14

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EXAMPLE 9
$; &; ';
For Bond # ,
%$ ; &$$; &$&$$;
…

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As in Example 9, 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, then the IRR will be similar to
both.
Nevertheless, it is worth remarking that these situations are not
usual at all.

In Example 9, Equations 13 and 14 were second degree because the

longest maturity were two years. In general, both equations are higher
degree and may contain radicals. Thus, there is no analytic solution,
and IRR and ())_*+, must be estimated with numerical
procedures.

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IMPLIED FORWARD RATES
Consider two future dates 0 - - .. The implied forward
rate /,0 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.

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 1
Actually, 1 ,1 could represent the amount of
money that we might recover at 0 if we invested €& at
/.

,1 would be the obtained interest rate if right now we

were able to replicate the investment with only two cash
flows at and ..
Readers with some notions about derivatives will
understand that /,0 is the interest rate of forward or
future contracts if they were available in a derivative
market.
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 EXAMPLE 10
Consider the TSIR 4& $, 56 and 4' $, 57 and
suppose that there are two available pure discount
bonds
$; &; $ '
.
56$ &$$$ 57$ &$$$

Consider Portfolio 857$; 56$ , which means that we

sell 57$ units of the first bond and we purchase 56$
units of the second one.

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In general, implied forward rates are easy to obtain from
Equation

0 / 0 /
& 0 & / 9 & /,0 , 17

It is easy to see it graphically

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EXAMPLE 11
Consider the information from the example 10 about
the TSIR. So the spot rates would be …

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The implied rate “amplifies” the increasing or
decreasing effect of the TSIR.
In the example above, 2,06% > 2,04% , and
therefore the difference , 8 2,08% 8 2,04% 4 @A, is
higher than 8 2,06% 8 2,04% 2 @A.
So, when ' > &, the increment of the forward rate,
&,' , is higher.

If the TSIR were decreasing the fall would be also higher.

For instance, for 2,02%, we would obtain
1 1 0,0202
, 81 8 1 '%.
1 1 0,0204
So, when ' - & , the forward rate, &,' , is lower.

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EXAMPLE 12
Compute the implied forward rate, &,' , if & B% and
' C%.

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EXAMPLE 13
Compute the implied forward rate, &,' , if & B% and
' D%.

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 The discussion above also applies for logarithmic interest
rates and logarithmic forward rates

which satisfy
∗
,1 *+, 1 ,1 ,
and are given by
∗ ∗
1 E∗ 1 ,E .
∗9 1
FG+HIG, ℎK 1 KGL 1 1 1 9
1 ∗ ∗ 1 ∗
1 ,1 → 1 E ,E

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

∗N ∗
1 E∗ 1 ,E

∗ ∗ ∗
. 1 .8 ,1 18

∗ ∗
∗
0 08/ /
/,0
08/

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EXAMPLE 14
Suppose that 5 D, '% and D& B%, and compute
5,D& .

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EXERCISES (II)

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