FIXED INCOME

Securities & Markets

Francois Le Grand
Associate Professor of Finance at EM Lyon Business School
email: legrand@em-lyon.com

Second Class

CLASS II
INTEREST RATES

Summary of Class I

1
2

We know what a bond is

We have described the market organization
1
2
3

3
4

Issuers
Buyers
Dealers

We have discussed about the main risks

We have presented an international overview of FI markets:
1
2
3

US
Japan
Europe: UK, France

Plan of Class II

Introduction

Simple interest rates

Compounded rates

Interest rates and time

1 - Introduction

Some definitions

The idea at the very heart of fixed income is that time is money.
Why?
When you lend money, you will give up the opportunity of
consuming more or of investing in any physical asset. You
therefore need a compensation for this renouncement this
compensation is the interest paid by the borrower.
In any borrowing/lending relationship, the borrower pays the lender
a fee, which is the interest of the loan. The interest rate is the
compensation, proportional to the lending amount.

Some definitions
Definitions regarding transferring money through time.
Preliminary notations: t1 < t2 are two dates. Mt is a given
amount of money at the date t.
The first operation consists in transferring money from today t1 to
another date t2 in the future (typically savings). Compounding is
the process allowing to compute Mt2 given the current amount
Mt1 .
The other operation consists in investing money today t1 to obtain
a given amount Mt2 in the future. Discounting is the process
allowing to compute Mt1 given the future amount Mt2 .

2 - Simple interest rates

Simple interest rates

First example.
You save for 1Y the amount of 10 000 e with an interest rate of
6%. What is the amount of interest you will receive? How much
will you get in 1Y?

Simple interest rates

First example.
You save for 1Y the amount of 10 000 e with an interest rate of
6%. What is the amount of interest you will receive? How much
will you get in 1Y?
Solution.
The interest you will receive is equal to 6% of the saved amount =
10000 e = you will get an interest amount I of:
I=

6
10000 = 600
100

The total amount will be equal to the interest plus the initial
saving= 600 + 10000 = 10600 e.

Simple interest rates

Second example.
We consider that you save 10 000 e for 2Y, with an (annual)
simple interest rate of 6%. What is the amount of interest you will
get? How much will you have in 2Y?

Simple interest rates

Second example.
We consider that you save 10 000 e for 2Y, with an (annual)
simple interest rate of 6%. What is the amount of interest you will
get? How much will you have in 2Y?
Solution.
Since interest rates are simple, you will get for each year the same
6
amount I = 100
10 000 = 600.
The total amount you will have in 2Y will be
10000 + 2 600 = 11200.

Simple interest rates

Generalization.
Consider an initial amount M0 , saved with a simple (annual)
interest rate r and a maturity of n years. The amount of interest
In received at maturity and the future amount Mn are respectively:
In = n r M0
Mn = M0 (1 + n r)

Simple interest rates: Payment in advance

Payment in advance.
Until now, we have made an implicit assumption: Simple interest
rates are paid in arrears, at maturity.
We assume now that interest rates are paid in advance, at the
beginning of the contract. The amount you borrow is therefore not
anymore what you get (because you pay interest at the opening),
but what you pay at maturity.
Intuitively, the interest rate in arrears will be larger than the one in
advance (for identical cash flows).
Notations: the subscript a refers to the in advance contract (a for
ex ante) and p to the in arrears loan (p for ex post).

Simple interest rates: Payment in advance

First example.
Lets consider that you borrow for 1Y the amount of 10 000 e with
an interest rate of 6%.
What is the amount of interest you will pay?
How much will you receive today? pay in 1Y?
If you accept to repay 10 600 e in 1Y (cf. payment in arrears), how
much will you receive today?

Simple interest rates: Payment in advance

Solution.
The interest rate is simple: (i) the amount you borrow is the
amount you pay back at maturity and (ii) the interest payment is
paid at the beginning of the contract and thus diminishes the
amount you receive.
The terminal payment = borrowed amount of 10 000 euros (no
interest payment).
The interest you will pay is equal to 6% of the borrowed amount of
10000 e = you will get an interest amount I of:
I=

6
10000 = 600
100

This interest is paid today, meaning that it decreases the amount

you receive today. What you get is equal to 10000 600 = 9400 e.

Simple interest rates: Payment in advance

If you accept to repay in 1Y the same amount as in the in arrear

loan = 10600 e, it simply means that in the in advance loan, you
borrow 10600 e, with a yield of 6%. You pay an interest equal to:
10600 6% = 636. You only receive 10600 636 = 9964 e today.
To get the same cash flows as in the arrear loan, the in advance
one should demand a smaller rate.

Simple interest rates: Payment in advance

Second example.
You enter a 2Y loan with an annual in advance simple rate. You
want to obtain 10 000 e today. What should be the in advance
rate, in order to replicate the flows of a in arrears loan with a yield
of 6%?

Simple interest rates: Payment in advance

Solution.
With an in arrear loan, you have two flows:
1

Today, you receive 10000 e

In two years, you pay: 10000 (1 + 2 6%) = 11200 e.

Let note ra the in advance yield. To replicate in arrears flows, you

have to borrow 11 200 e with the in advance loan. You will pay
the interest 2 ra 11200 and receive today: 11200 (1 2 ra ).
To equalize 10 000 e (the initial in arrear flow), we have:
11200 (1 2ra ) = 10000
2ra = 1 100/112 = 12/112
ra 5.36%

Simple interest rates: Payment in advance

Generalization.
Consider a loan of an amount S, borrowed with a simple (annual)
in advance interest rate ra and a maturity of n years. The
amount of interest In paid at the beginning, the initial amount
received M0 , and the future amount paid Mn are respectively:
In = n ra S
Mn = S
M0 = S (1 n ra )

Simple interest rates: Payment in advance

Equivalence with the payment in arrears.
We determine the interest rate rp of a in arrear loan (with the
same maturity n) allowing to replicate the in advance contract
with the following flows:
Mn = S

M0 = S(1 n ra )

It means that borrowing the amount M0 with an in arrear loan

should lead to a repayment of Mn or:
M0 (1 + n rp ) = Mn
S(1 n ra )(1 + n rp ) = S
(1 n ra )(1 + n rp ) = 1
n rp =

n ra
1 n ra

Simple interest rates: Payment in advance

The interest rates ra and rp of two in advance and in arrear

loans with the same maturity and the same flows verify the
following relationship:
(1 n ra )(1 + n rp ) = 1

Remark 1: Although different, both interest rates ra and rp have

the same order of magnitude (i.e. are similar at the first order).
Remark 2: The previous relationship implies that rp > ra , which
is consistent with our initial intuition.

3 - Compounded rates

Interest rates: Compounded rates

First example.
Lets consider that you save for 1Y the amount of 10 000 e with an
interest rate of 6%.
What is the amount of interest you will receive?
How much will you have in 1Y?

Interest rates: Compounded rates

First example.
Lets consider that you save for 1Y the amount of 10 000 e with an
interest rate of 6%.
What is the amount of interest you will receive?
How much will you have in 1Y?
Solution.
The interest you will receive is equal to 6% of the saved amount =
10000 e = you will get an interest amount I of:
I=

6
10000 = 600
100

The total amount will be equal to the interest plus the initial
saving= 600 + 10000 = 10600 e.

Interest rates: Compounded rates

Second example.
We consider that you save for 2Y. More precisely, you save
10 000 e with an (annual) interest rate of 6%. We suppose
additionally that interest rates are compounded.
What is the amount of interest you will get?
How much will you have in 2Y?

Interest rates: Compounded rates

Solution.
Compounded interest rates mean that they are reinvested at the
end of the year and that they also pay interests.
At the end of the first year, you will get the interest amount I1 :
I1 =

6
10 000 = 600
100

The total saving amount M1 you will have in 1Y will be 10000 +

600 = 10600 e.
This total amount is reinvested (and not only the initial amount,
as for simple interest rates) and produces interests. At the end of
the second year, you will have the interest amount I2 :
I2 =

6
10 600 = 636
100

Total amount in 2Y = 10000 + 600 + 636 = 11236 e.

Interest rates: Compounded rates

Generalization.
Consider an initial amount M0 , saved with a compounded (annual)
interest rate r and a maturity of n years. The amount of interest
In received at maturity and the future amount Mn are respectively:
I1 = r M0
M1 = (1 + r)M0
I2 = r M1 = r(1 + r)M0
M2 = M1 + I2 = (1 + r)M1 = (1 + r)2 M0
..
.
In = r Mn1
Mn = (1 + r) Mn1 = (1 + r)n M0

Interest rates: Compounded rates

Consider an initial amount M0 , saved with a compounded (annual)

interest rate r and a maturity of n years. The future value Mn of
M0 is:
Mn = M0 (1 + r)n

4 - Interest rates and time

Interest rates: Time matters

2 ways for time to influence interest rates.

1

Period. Until now, we have only considered periodic interest

rates. But in fact, loans and savings may involve different
types of interest rates, like monthly interest rates or
semiannual ones.

Day count convention. What about investments during a

given number of days (and not a whole number of periods)?

Day count conventions

We consider an annual simple interest rate.
You invest 100 e on a saving account the 1st of November.
What is the amount of interest you have earned at the 21st of
the same month?
One needs converts those 20 days into a yearly fraction.
No single rule. One must adopt a day count convention
depending on the security and the market.
Some examples of day count conventions:
Actual/360: The preceding 20 days becomes the fraction
20/360 of a year (used only in short term contracts).
Actual/365: we get the fraction 20/365.
Actual/Actual: We have to take into account leap years.
Since 2012 is leap, we obtain the fraction: 20/366.

Day count conventions

2 remarks:
1

Once the convention chosen, all preceding results still hold

(except that the period fraction n could be real)

When counting days, actual means the actual number of days

btw the maturity date and the initial date. We will consider
that the period start date (i.e., today) is exclusive, and the
relevant redemption date is inclusive. Between July, 1st and
July, 5th, one should count 4 days.

Day count conventions

Simple interest rates. They are typically used for short term
operations (compounding does not matter that much)
convention = Actual/360.
Example. You lend 1000 e on October, 12th with a simple
interest rate of 6%. How much will you get back at maturity,
December, 18th one year later? (in a non-leap year)

Day count conventions

Simple interest rates. They are typically used for short term
operations (compounding does not matter that much)
convention = Actual/360.
Example. You lend 1000 e on October, 12th with a simple
interest rate of 6%. How much will you get back at maturity,
December, 18th one year later? (in a non-leap year)
Solution. The contract counts 31 12 + 30 + 18 + 365 = 67 + 365
days. The received interest is therefore:
1000 365+67
360 6% = 72 e. The total repayment is: 1072 e.

Day count conventions

Compounded interest rates. This the main standard rate

calculation (increasingly) Usual convention = Actual/Actual.
Example. You lend 1000 e on October, 12th with a compounded
interest rate of 6%. How much will you get back at maturity, the
18th of December one year later?

Day count conventions

Compounded interest rates. This the main standard rate

calculation (increasingly) Usual convention = Actual/Actual.
Example. You lend 1000 e on October, 12th with a compounded
interest rate of 6%. How much will you get back at maturity, the
18th of December one year later?
Solution. The contract counts 31 12 + 30 + 19 = 67 + 365 days.
The total repayment is therefore:
365+67
1000 (1 + 6%) 365 1071.40 e. The received interest is:
71.40 e.

Day count conventions

Exercise.
I have the opportunity to invest 2000e with an annually
compounded interest rate of 6%. I want to obtain 2050e. How
long (in days) should I wait (Actual/365 convention)?

Day count conventions

Exercise.
I have the opportunity to invest 2000e with an annually
compounded interest rate of 6%. I want to obtain 2050e. How
long (in days) should I wait (Actual/365 convention)?
Solution. Let denote by t the investment length. At the end of t, I
receive 2000(1 + 6%)t , which should be equal to 2050.
2050
2000




2050
t
ln (1 + 6%) = ln
2000
ln (2050) ln (2000)
t=
ln (1 + 6%)
0.4237 . . . Y 154.7 D
(1 + 6%)t =

(be careful the conversion in days is based on the exact result, not
on the approximation of 0.42Y)

Time basis and periodic interest rates

The period of a given interest rate is the time length that you
should wait before earning the interest rate.
The basis of an interest rate is the time length, in which the
(periodic) interest rate is expressed. The basis is typically the year.
Examples. You save 100 e with the following interest rates:
a weekly interest rate of 0.5% expressed on a weekly basis
After one week, you earn 0.5e.
a monthly interest rate of 2% expressed on a monthly basis
After one month, you earn 2e.
a semiannual interest rate of 6% expressed on a semiannual
basis After 6 months, you earn 6e.
a semiannual interest rate of 12% expressed on a yearly basis
After 6 months, you earn 12
2 = 6e.
a monthly interest rate of 24% expressed on a yearly basis
After 1 month, you earn 24
12 = 2e.

Time basis and periodic interest rates

Equivalent interest rates.

Example 1.
You borrow 100e with a monthly interest rate of 1.25% (monthly
basis). How much do you reimburse in 1Y? What is the equivalent
effective annual rate?

Time basis and periodic interest rates

Equivalent interest rates.

Example 1.
You borrow 100e with a monthly interest rate of 1.25% (monthly
basis). How much do you reimburse in 1Y? What is the equivalent
effective annual rate?
Solution. In one year, you will repay: 100(1 + 1.25%)12 = 116.07e.
The equivalent annual interest rate rY is therefore:
rY =

116.07
1 16.07%
100

Time basis and periodic interest rates

Example 2.
You borrow 100e with a semiannual interest rate of 10% expressed
on a yearly basis. How much do you reimburse in 1Y? What is the
equivalent effective annual rate?

Time basis and periodic interest rates

Example 2.
You borrow 100e with a semiannual interest rate of 10% expressed
on a yearly basis. How much do you reimburse in 1Y? What is the
equivalent effective annual rate?
2
Solution. In one year, you will repay: 100(1 + 10%
2 ) = 110.25e.
The equivalent annual interest rate rY is therefore:

rY =

110.25
1 10.25%
100

Time basis and periodic interest rates

Exercise: (m = month(s), and Y = year(s) 1Y = 12m)
Initial Rate
Period Basis Rate
2m
1Y
3%

Converted rate
Period Basis Rate
1Y
1Y

4m

8m

4%

6m

1Y

3m

9m

5%

1m

3m

6m

1Y

6%

3m

6m

1m

1Y

5%

1m

2m

2m

9m

4%

6m

1Y

7m

8m

3%

2m

5m

Time basis and periodic interest rates

Exercise: (m = month(s), and Y = year(s) 1Y = 12m)
Initial Rate
Period Basis Rate
2m
1Y
3%

Converted rate
Period Basis Rate
1Y
1Y
3.04%

4m

8m

4%

6m

1Y

6.03%

3m

9m

5%

1m

3m

1.66%

6m

1Y

6%

3m

6m

2.98%

1m

1Y

5%

1m

2m

0.83%

2m

9m

4%

6m

1Y

5.38%

7m

8m

3%

2m

5m

1.86%

Time basis and periodic interest rates

General case. We consider two equivalent interest rates r1 and r2 .

They are expressed on two different basis B1 and B2 and represent
different periods P1 and P2 . The following relationship holds (basis
and periods are expressed using the same unit, e.g. the month):


P1
1+
r1
B1

1
P1


1
P2
P2
= 1+
r2
B2

Time basis and periodic interest rates

Application of the preceding formula. Let r1 be a semiannual
interest rate expressed on an annual basis. Compute r2 , the
monthly interest rate expressed on a quarterly basis.
1 
1

6
1
1
6
r1
= 1 + r2
1+
12
3
Direct method. I consider the investment of 1 e for one month.
The same investment considering 2 equivalent interest rates yield
the same output:
r1 :
r2 :

1
r1 )1/6
2
1
1 (1 + r2 )1/1
3
1 (1 +

Time basis and periodic interest rates

Remarks and conventions:
For sake of comparison, periodic interest rates are very often
expressed on a yearly basis.
In the US market: semiannual interest rates (and coupons)
expressed on a yearly basis.
In the e market: annual interest rates (and coupons)
expressed on a yearly basis.
By default, we consider that any periodic interest rate will be
expressed on a yearly basis.
Example. You save 100e with a semiannual rate of 8%. After 2

4
years, you will obtain 100 1 + 8%
= 116.99e.
2