Introduction to Financial Derivatives

EC3011- Introduction to Financial Derivatives

Interest and Forward Rates - Solutions

Asena Temizsoy
City, University of London

2017-2018

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Introduction to Financial Derivatives

1 Interest and Forward Rates - Solutions

Exercise Book 4.1

Exercise Book 4.4
Exercise Book 4.5

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.1

Exercise Book 4.1

A bank quotes you an interest rate of 14% per annum with quarterly
compounding. What is the equilavent rate with

a) continuous compounding?

b) annual compounding?

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.1

Solution to Exercise Book 4.1

a)  rm mn
erc n = 1 +
m
rm = 14%, m = 4, n = 1
14% 4∗1
 
rc ∗1
e = 1+
4
rc = 13.76%
b)
(1 + rm1 /m1 )m1 = (1 + rm2 /m2 )m2
m1 = 1, m2 = 4
(1 + r1 /1)1 = (1 + r4 /4)4
(1 + r1 )1 = (1 + 14%/4)4
r1 = 14.75%
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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.4

Exercise Book 4.4

An investor receives $1 100 in one year in return for an investment of

$1 000 now. Calculate the percentage return per annum with:

a) Annual Compounding
b) Semiannual Compounding
c) Monthly Compounding
d) Continuous Compounding

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.4

Solution to Exercise Book 4.4

Apply terminal value of an investment formula;

rm mn
I(1 + )
m

a) Annual Compounding where m = 1, n = 1

$1000 ∗ (1 + r1 ) = $1100

r1 = 10%
b) Semiannual Compounding where m = 2
r2 2
$1000 ∗ (1 + ) = $1100
2
r2 = 9.76%
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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.4

Solution to Exercise Book 4.4

c) Monthly Compounding where m = 12

r12 12
$1000 ∗ (1 + ) = $1100
12
r12 = 9.57%

d) Continuous Compounding

$1000 ∗ erc n = $1100

rc = 9.53%

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.5

Exercise Book 4.5

Suppose that zero interest rates with continuous compounding are as

follows.
Maturity(Months) Rate(% per annum)
3 8.0
6 8.2
9 8.4
12 8.5
15 8.6
18 8.7

Calculate forward interest rates for the second, third, fourth, fifth and
sixth quarters.

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.5

Solution to Exercise Book 4.5

r(0, 0.25) = 8.0%, r(0, 0.5) = 8.2%, r(0, 0.75) = 8.4%

r(0, 1) = 8.5%, r(0, 1.25) = 8.6%, r(0, 1.5) = 8.7%

Forward interest rate for the second quarter

Ier(t,t2 )(t2 −t) = Ier(t,t1 )(t1 −t)+f (t,t1 ,t2 )(t2 −t1 )

Ier(0,0.5)(0.5−0) = Ier(0,0.25)(0.25−0)+f (0,0.25,0.5)(0.5−0.25)

8.2% ∗ 0.5 = 8.0% ∗ 0.25 = 0.25 ∗ f (0, 0.25, 0.5)
f (0, 0.25, 0.5) = 8.4%

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Introduction to Financial Derivatives
Interest and Forward Rates - Solutions
Exercise Book 4.5

Solution to Exercise Book 4.5

Forward interest rate for the third quarter

Ier(0,0.75)(0.75−0) = Ier(0,0.50)(0.50−0)+f (0,0.50,0.75)(0.75−0.50)

f (0, 0.50, 0.75) = 8.8%
Forward interest rate for the fourth quarter

Ier(0,1)(1−0) = Ier(0,0.75)(0.75−0.50)+f (0,0.75,1)(1−0.75)

f (0, 0.75, 1) = 8.8%
Forward interest rate for the fifth quarter

Ier(0,1.25)(1.25−0) = Ier(0,1)(1−0)+f (0,1,1.25)(1.25−1)

f (0, 1, 1.25) = 9%
Forward interest rate for the sixth quarter

Ier(0,1.50)(1.50−0) = Ier(0,1.25)(1.25−0)+f (0,1.25,1.50)(1.50−1.25)

f (0, 1.25, 1.50) = 9.2% 10/10