Contents

Yield Curve − Interest Rate Measures ...................................................................................................................... 3

Introduction .......................................................................................................................................................... 3
Key concept .......................................................................................................................................................... 3
Importance of Yield Curve Terminology ............................................................................................................... 3
1. Yield to maturity : ..................................................................................................................................... 3
2. Par yield & Spot rate................................................................................................................................. 3
Yield Curves: The Spreadsheet ............................................................................................................................. 4
Yield Curves Based on Different Measures .......................................................................................................... 6
The Role and Implications of Forward Rates ........................................................................................................ 9
The Role and Implications of Forward Rates continued ...................................................................................... 9
The Role and Implications of Forward Rates ...................................................................................................... 10
Forward Rates Exercise ...................................................................................................................................... 10
Implied Future Spot Rate................................................................................................................................ 11
Implied Future Spot Rate.................................................................................................................................... 12
To illustrate which inputs we need for the above equation, let’s look at the shorter leg of the barbell. ..... 13
Exercise ............................................................................................................................................................... 14
Full Valuation Approach: Effective Duration/Convexity and Key Rate Durations .................................................. 18
Introduction ........................................................................................................................................................ 18
Overview of Effective Duration and Convexity (Full Valuation Approach) ........................................................ 18
Binomial Interest Rate Trees and Bond Price Trees ........................................................................................... 18
Mechanics of Full Valuation Approach ............................................................................................................... 19
How to calculate effective duration for full valuation ................................................................................... 19
Contrast the full valuation approach with the modified duration approach. ................................................ 20
Volatility Assumption ......................................................................................................................................... 20
Callable Bond Example Using the Spreadsheet .................................................................................................. 20
Analysis of Callable Bond Example Using the Spreadsheet................................................................................ 22
Convexity ............................................................................................................................................................ 23
Effective Convexity and Full Valuation Summary ............................................................................................... 23
Key Rate Durations ............................................................................................................................................. 24
Key Rate Duration (KRD) Spreadsheet Example ................................................................................................. 25
Analysis of Key Rate Durations (KRDs) ............................................................................................................... 26
Exercise ............................................................................................................................................................... 26
Yield Curve Trades: Computing and Decomposing Expected Returns ................................................................... 29
Objectives ........................................................................................................................................................... 29
 Expected Returns on Bond Positions.................................................................................................................. 29
Rolldown Return ................................................................................................................................................. 30
Value of Convexity .............................................................................................................................................. 30
Yield Volatility ..................................................................................................................................................... 31
Expected Return from Interest Rate View.......................................................................................................... 31
Summary of Expected Returns ........................................................................................................................... 32
Estimating the Inputs used to Decompose Expected Returns ........................................................................... 32
Decomposing Expected Returns: A Practical Example ....................................................................................... 32
Walking Through Return Components ............................................................................................................... 35
Summary of Main Points .................................................................................................................................... 36
Hedging Interest Rate Risk Using Caps and Floors ................................................................................................. 40
1. Introduction ................................................................................................................................................ 40
2. Interest rate cap and floor.......................................................................................................................... 40
Valuation of Caps and Floors .............................................................................................................................. 41
Cap value ............................................................................................................................................................ 42
Current cap value ............................................................................................................................................... 42
Caps and Floors Combined with Floating-Rate Bonds ....................................................................................... 43
Valuing Caps / Floors Using the Spreadsheet ..................................................................................................... 44
Combining Caps and Floors – Collars ................................................................................................................. 45
Floating-Rate Bonds Containing Embedded Caps and Floors ............................................................................ 46
Zero-Cost Collars ................................................................................................................................................ 47
Analysis of Zero-Cost Collar Example ................................................................................................................. 48
Caps and Floors vs. Options on Bonds................................................................................................................ 48
Questions:........................................................................................................................................................... 49
Yield Curve − Option-Adjusted Spreads ................................................................................................................. 51
1. Introduction .................................................................................................................................................... 51
2. Nominal Spreads............................................................................................................................................. 51
3. Zero-Volatility Spreads (Z-Spreads) ................................................................................................................ 52
4. Option-Adjusted Spread (OAS) ....................................................................................................................... 52
Summary of Yield Spreads .................................................................................................................................. 54
6. Yield Spreads: A Practical Example ................................................................................................................. 54
6.Analysis of Spreadsheet Computation of Yield Spreads.................................................................................. 55
7. Influence of Yield Volatility Assumption on OAS ............................................................................................ 56
8. OAS Analysis of Mortgage-Backed Securities ................................................................................................. 57
9. Advantages and Drawbacks of Different Yield Spread Measures .................................................................. 58
10. Question ....................................................................................................................................................... 59
Yield Curve − Interest Rate Measures
Introduction
After this module, the learner will be able to:

- Explain why spot rates (zero-coupon rates) are appropriate rates for valuing bond and derivative cash
flows.
- Explain how implied future spot rates are calculated.
- Describe implied future spot rates as “break-even rates.”
- Be able to compute a barbell–bullet trade profit and loss given the spreadsheet.
- Be able to mathematically show that duration-neutral, self-financing trades breakeven if forward rates
are realized.
- Explain why interest rate views need to be carefully analyzed in the context of forward and implied
future spot rates.

Key concept
A key concept in fixed-income analysis is the “yield” or an “interest rate,” which many investors use either as a
measure of a bond’s expected return or as a metric to measure relative value across bonds.

There are, however, a number of different “yield” or “rate” measures that are commonly used, so our first job
is to review these measures and discuss the benefits and limitations of each interest rate measure.

This approach will provide you with a better understanding of the interrelationships between yield measures
and which measures are most appropriate for valuation purposes.

Importance of Yield Curve Terminology

1. Yield to maturity :
- YTM is the discount rate that makes the bond’s sum of discounted future cash flows equal to its market
price.
- Every bond has only one yield to maturity. It is a simple and convenient measure. However, it has
limiting assumptions and many drawbacks.
- The biggest drawback of YTM is that it assumes bond cash flows are reinvested at the YTM, which is an
unrealistic assumption. The YTM ignores valid information contained in the term structure of interest
rates (rates unique to each maturity in the future).
- Further, constructing a yield curve from different maturities based on YTM ignores the fact that bonds
can trade at different YTM based on whether they are discounts or premiums. A partial improvement
to this drawback is to use the par yield measure.
- Drawbacks: Assumes bond cash flows are reinvested at the yield to maturity. Ignores valid
information. Ignores that bonds can trade at different YTM based on whether they are discounts or
premiums.

2. Par yield & Spot rate

- Definition The spot rate measure addresses both of the problems associated with YTM or par yield. A
spot rate can be thought of as a zero-coupon bond rate for a given maturity.
- Zero-coupon bond rates (yields) do not depend on reinvestment assumptions. Another way of saying
this is that you can guarantee a return (yield) by purchasing a zero and holding it to maturity. By graphing
 the yields on zero-coupon bonds, we can create a spot rate curve. To price a bond, each cash flow can
then be discounted at the prevailing spot rate corresponding to the timing of the cash flow. For
convenience, we are ignoring some technical details regarding the construction of an arbitrage free spot
rate curve in order to focus on concepts rather than the cumbersome process of term structure
modelling.
- Spot Rate (Yield) Summary:
Not subject to reinvestment risk Pure term structure of interest rates Appropriate for discounting cash
flows (bond and derivative pricing)
- Sport rate VS Forward rate:
A spot rate, as a multi-period rate, can be unbundled even further into a product of one-period forward
rates. VS A forward rate is a rate agreed on today for a loan between any two future dates.
- Ví dụ a loan contract may specify an interest rate of 6% on an amount borrowed one year from now
and to be repaid in two years time. The 6% interest rate on the loan is called a one-year forward rate
starting one year from now.
As a result, an n-year spot rate is simply a special case of an n-year forward rate on a loan that starts
today at year t = 0 and matures n-years from now.
In the same way that a current spot rate can be broken down into a product of one-period forward
rates, a future implied spot rate can be obtained using the one-period forward rates. A future implied
spot rate is a synthetic rate created by taking existing spot rates and generating a future spot rate given
current forward rates.
For example, assuming the three one-year forward rates beginning one, two, and three years from
today are 6%, 6.5%, and 7% respectively, the implied future three-year spot rate one year from today
can be computed as a product of these forward rates, namely
[(1 + 0.06)×(1 + 0.065)×(1 + 0.07)]1/3 – 1 = 6.50%.
- In summary, par yield and yield to maturity represent a one-rate summary measure of a bond’s yield.
In practice, bond valuation models use a different spot rate to discount each unique cash flow
according to its timing. Forward rates are implied by existing spot or zero-coupon rates. Forward rates
can be very powerful tools for understanding the market’s collective pricing of future interest rates,
which we will study later in this session.

Yield Curves: The Spreadsheet

Objective: After this lesson, the learner will be able to use the spreadsheet to draw a yield curve.

Each of the interest rate measures discussed earlier in this module can be used to construct a yield curve and
these yield curves contain the same information in the sense that each type of yield curve can be computed from
each other type. An intuitive understanding of the relationship between the different yield curves and their
interpretation is crucial for fixed-income analysis.

We are going to take a closer look at the Excel spreadsheet used for this module. The spreadsheet allows the
user to obtain one type of yield curve from another and then examine their interrelationships.

Note: You may download the spreadsheet by clicking the download button. Be aware that the values seen in
these samples are the defaults, so unless you changed the spreadsheet you will not need to enter these sample
values when opening the spreadsheet.

Mini-Module 1.xlsm
The first input box on your spreadsheet, labeled “Please specify
your type of inputs” (Figure 2) allows you to specify which type of
bond information or interest rates you would like to input in order
to generate different types of yield curves.
The first option on the list (“Bond Characteristics”) requires a set
of bond prices, corresponding coupons (in percent), and years to
maturity to be entered in order to generate yield curves based on
spot rates, forward rates, par yields, and implied future spot
rates. The bond maturity inputs should range from less than or
equal to one year to thirty years as this is the range used for the
yield curves that the program generates. Because the accuracy of
the yield curves generated increases as more bond maturities are
entered, the algorithm requires you to input at least four bonds
of different maturities.
Alternatively, you may specify either a set of spot rates, forward
rates, or par yields (by choosing options 2, 3, or 4 in the first list
box) to generate yield curves. For convenience, the rest of the
analysis and examples will assume we begin with spot or zero-
coupon rates.
 One more input will be needed to
compute the implied future spot
rate curve, namely its base date.
Any base date ranging from one
year to ten years from today may be
selected using the second input box:

Once these inputs are made, the

graph shows the four yield curves—
spot rates, one-period forward
rates (in the spreadsheet one period
is one year), par yields, and implied
future spot rates.
Next, lets see an example.

Yield Curves Based on Different Measures

Note that the graph's the horizontal axis label “Maturity” corresponds to the maturity of each rate measured in
years from today. It is not necessarily equal to the period covered by a certain rate.

For example, a five-year maturity covers a period of five years from today for a spot rate or par yield.

However, it corresponds to a forward rate covering a one-year period only starting four years from today and
maturing in five years. Similarly, the implied future spot rate at a five-year maturity would cover a period
starting N years from today (with N specified by the user and less than five years) and maturing in five years
from today.

If you examine the graph, the first thing you will notice is that unless you entered a flat yield curve to begin
with (i.e., all rates are the same), the curves differ from each other.
Let’s start with an upward sloping spot rate curve. So either enter a monotonically upward sloping spot rate
curve directly into the gray input box or enter the corresponding bond characteristics that result in such a yield
curve. As you will remember, upward sloping is the most common yield curve shape observed empirically.
Below is an example to guide our discussion.
You will notice that the forward rate curve lies above all other yield curves, followed by the current spot rate
curve and the par yield curve (in that order). The ordering is reversed for an inverted (or downward sloping
yield curve as shown below)

This pattern makes intuitive sense. Forward rates magnify any variation in the slope of the spot curve as they
represent the marginal reward for extending the maturity by one period (one year in our case). In contrast, spot
rates, because they are the product of the corresponding one-period forward rates, measure the average return
from today until maturity. Similarly, par yields are averages of different spot rates because they are a one-value
summary measure of a bond’s yield. Therefore, the par curve is the flattest of all yield curves.

From the calculation of implied future spot rates illustrated above, the location of the implied future spot rate
curve relative to the other yield curves is not as clear.

Future Spot Rate Curve:

Will always lie above the current spot rate curve if the spot rate curve is upward sloping.
Will always lie below the current spot rate curve if the spot rate curve is downward sloping.

However, the implied future spot rate curve may lie above or below the forward rate curve.

Implied Future Spot Rate Curve:

Its relative location depends on the curvature of the spot rate curve.

If the spot rate curve is upward sloping but concave (i.e., it flattens out over the maturity range), then the implied
future spot rate curve portion toward the long end of the maturity spectrum may lie above the forward rate
curve, because the marginal reward of extending the maturity that is captured by the forward rate becomes very
small (the corresponding portion of the spot rate curve may be almost flat). Otherwise, the implied future spot
rate curve will lie above the forward rate curve if spot rates are upward sloping. Similar arguments apply to
downward sloping spot rate curves. Verify these relationships by entering spot rate curves with different
curvatures / concavities.

You will also notice from the graph that the implied future spot rate curve always “touches” the forward rate
curve at its starting point, regardless of the base date you choose. This is definitional. The first implied future
spot rate covers the same period as the corresponding forward rate. So, for example, if your implied future spot
rate base date is two years from today, then the first point on the curve will show up for a maturity of three years
from today (i.e., the first implied spot rate will start two years from now and mature three years from now),
which is the same as the corresponding one-period forward rate. All subsequent points, however, will differ
between the implied spot rate and the forward rate curve because the former covers increasingly longer periods
whereas the latter is a constant maturity curve—each rate corresponds to the same interval, which is one year
in our case.

The Role and Implications of Forward Rates

- Forward rates have a very useful interpretation that plays an important role in fixed-income analysis—
they can be viewed as break-even rates.

Their interpretation can be easily seen from the relationship between spot and forward rates. By construction,
the future spot rates one year from today implied by the corresponding forward rates, if realized, would make
all government bonds earn the same return over the next year as the riskless one-year zero-coupon bond. Near-
term returns are equalized if all bonds with higher yields than the short-term rate suffer capital losses that offset
their yield advantage.

- Practically, this means that any “bet” on interest rates is a “bet” not against the observed yield curve
(whether par or spot), but a bet against forward rates implied by the yield curve.

An upward sloping yield curve and corresponding higher forward rates may or may not mean that “the market
expects higher future rates” because it could be that the market is demanding higher risk premiums to hold
longer-term bonds relative to short-term bonds. We will not attempt to answer questions regarding various term
structure theories in this course, but instead will focus on practical applications of relationships and trades that
consider forward rates and implied future spot rates objectively.

The Role and Implications of Forward Rates continued

Suppose the one-year spot rate = 5%, the two-year spot rate = 6% implying a forward rate f1,2 of approximately
7%. The yield premium of the forward rate above the spot rate is f1,2 – s0,2 = 7% – 6% = 1%. The positive
difference between the two spot rates means that an investor is able to earn a positive “carry” if he buys a two-
year zero and finances this position by selling a one-year zero. The investor’s profit will be equal to the carry plus
any capital gains or losses caused by yield changes. The investor makes money on this position unless the two-
year spot rate rises above f1,2 over the next one year, causing his position to suffer capital losses. Hence, the
break-even yield change is f1,2 – s0,2 , which would offset the carry effect. If the yield curve does not change,
then the carry s0,2 – s0,1 is equal to the rolling yield or horizon return of a zero (the zero’s maturity shortens by
one year, or, in other words, it “rolls down” the yield curve to a shorter maturity).

As such, the forward rate is termed the break-even rate. So, if the yield changes implied by the forward rates are
subsequently realized, government bonds of all maturities earn the same holding period return. In addition, all
self-financing positions break-even—that is, they generate a zero return. While in practice forward rates may
not be great predictors of future spot rates, it is imperative to understand that this is what is implied by the
pricing of bonds at any given time in the marketplace.

The Role and Implications of Forward Rates

- Forward rates have a very useful interpretation that plays an important role in fixed-income analysis—
they can be viewed as break-even rates.
Their interpretation can be easily seen from the relationship between spot and forward rates. By
construction, the future spot rates one year from today implied by the corresponding forward rates, if
realized, would make all government bonds earn the same return over the next year as the riskless
one-year zero-coupon bond. Near-term returns are equalized if all bonds with higher yields than the
short-term rate suffer capital losses that offset their yield advantage.
- Practically, this means that any “bet” on interest rates is a “bet” not against the observed yield curve
(whether par or spot), but a bet against forward rates implied by the yield curve.
An upward sloping yield curve and corresponding higher forward rates may or may not mean that “the
market expects higher future rates” because it could be that the market is demanding higher risk
premiums to hold longer-term bonds relative to short-term bonds. We will not attempt to answer
questions regarding various term structure theories in this course, but instead will focus on practical
applications of relationships and trades that consider forward rates and implied future spot rates
objectively.

Forward Rates Exercise

Objective: After this lesson, the learner will be able to compute the carry of a barbell trade.
 Suppose an investor expects the spot curve to flatten between the three-year and the five-year maturity
over the next year. He could exploit his interest rate view by entering a barbell–bullet trade. He could
sell a four-year zero (say for $1 million) and use the proceeds to buy equal market values ($500,000 each)
of the two-year and six-year zeros so that his aggregate position is duration-neutral (i.e., unaffected by
parallel yield curve shifts and only by changes in the shape of the yield curve). As the spot rate curve is
expected to flatten over a one-year horizon, the securities transacted are those whose maturities
correspond to the view after one year has passed.

Exercise: Compute the carry of the above barbell trade using the following formula. Carry is simply the
yield differential between the long and short positions in this trade.
Carry = (weight of 2-year leg x 2-year rate + weight of 6-year leg x 6-year rate – 4-year rate)

Solution
As can be seen, the position has a negative carry of –13 basis points.
= 0.5 × 3.60% + 0.5 × 5.18% – 4.52% = –0.1300%
In dollar terms, this corresponds to –$1,300 (–.0013% x $1 million) for the position sizes above. This is
because the spot rate curve is concave and hence the yield on the barbell portion of the portfolio (the
long positions in the two-year and six-year zeros) is lower than the yield on the bullet (the short
position in the four-year zero). Hence, to breakeven on the trade, the investor has to have capital gains
of at least 13 basis points or $1,300 to overcome the negative carry of the position.

Implied Future Spot Rate

Now, in the second list box on the Excel spreadsheet, choose to display the implied spot curve one year
forward.

Here is the table of rates that will be generated. We will focus on the final column
The implied future spot curve (implied by
the current forward rates) shows the rates
at which the barbell–bullet position would
exactly breakeven. This follows directly
from our discussion above. As we saw, the
future spot rates implied by the
corresponding forward rates, if realized,
would make all government bonds earn the
same return over a given horizon as the
corresponding riskless zero-coupon bond.
As a result, the realized returns on each of
the components of the duration-neutral
barbell–bullet trade offset each other so
that the combined trade breaks even.
Because the position starts with a negative
carry, the implied future spot rate curve, as
the breakeven curve, shows the amount of
implied flattening in the spot rate curve.
 Exercise: Perform the same carry calculation we made earlier, but this time use implied future spot
rates.
Carry = (weight of 2-year leg x 2-year rate + weight of 6-year leg x 6-year rate – 4-year rate)
Carry = 0.5 × 4.20% + 0.5 × 5.62% – 5.03% = –0.1191%
In dollar terms, this is equal to $1,191. You can see that this carry of –.1191% is smaller (less negative)
than the carry of –.13% when we looked at spot rates.

Implied Future Spot Rate

The carry implied by the future implied spot rate curve is smaller (less negative) because the implied
future spot curve needs to be flatter than the current spot rate curve in order for capital gains on the
position to offset its negative carry. As the barbell–bullet trade is set up in a way that is duration
neutral, parallel yield curve shifts won’t affect the value of the position. Positive capital gains can only
come from a flattening spot rate curve.
Before we continue to analyze this trade further, a few definitions will help us:

Roll-Down Return generated on a bond as its maturity shortens. This will be positive with an upward-
sloping yield curve.
Roll Yield: A bond’s horizon return given a scenario of unchanged yield curve; sum of yield and roll-
down return.

The return on the barbell–bullet position can be obtained by decomposing it into a roll-down return
(i.e., the return achieved if the spot rate curve remained unchanged over the next year) and the capital
gains implied by the difference in the implied spot rate and the unchanged spot rate curve scenario.

Now, let’s look at the one-year forward rates (in bold in the below table). From this curve, we can
compute a rolling yield differential between the barbell and the bullet of –34.50 basis points, computed
as:
 Rolling yield differential = (weight of 2-year forward rate x rate + weight of 6-year forward rate x rate –
rate of 4-year forward rate) = 0.5 × 4.20% + 0.5 × 6.69% – 5.79% = –0.3450%

So the four-year bullets rolling yield exceeds the barbell’s by 34.5 basis points or $3,450 on our
position. This is the loss we would suffer if the spot rate curve did not change over the one-year
horizon.

This loss can only be offset if the yields on each of the zeros change as implied by the future spot curve.
Compared with an unchanged spot curve, this would imply the following capital gains at the end of the
one-year horizon.
Note that the above equation uses durations, which for zero-coupon bonds equal their maturities. As
you will remember, duration is the approximate price sensitivity of a bond to a change in interest rates.
The relation is only approximate because the price-yield relationship isn’t exactly linear. Especially for
long-duration bonds, convexity plays an important role as well that we ignore here for simplicity, but
will capture in a future module.

To illustrate which inputs we need for the above equation, let’s look at the shorter leg of the barbell.

The two-year zero has one year remaining to maturity at the end of our one-year holding horizon.
Therefore, its duration will be one year as well at that time. To compute the capital gains on this zero-
coupon bond relative to the unchanged spot curve scenario, we need to compute the difference
between its implied one-year future spot rate one year from now (which is 4.20%) and the current one-
year spot rate (which is 3.00%). This would be equal to the one-year spot rate one year from now if the
spot curve remained unchanged. This yield difference multiplied by the weight of the shorter leg in the
barbell and its duration after the one-year horizon gives us the approximate capital gains on this
position relative to an unchanged spot rate scenario.

Performing these calculations on each of the legs of the barbell–bullet trade results in an approximate
capital gain of 0.34% or $3,400 for the entire position. This capital gain approximately offsets the
negative rolling yield differential, which illustrates that the trade breaks even if the implied future spot
rate curve is realized after one year.
 Rather than breaking up the return on the barbell–bullet trade into these two components, we can also
illustrate the break-even relationship by simply revaluing the zero-coupon bonds that make up the
position after one year has passed and assuming that the implied future spot rate curve is subsequently
realized.

In particular, we can compute the value of the position as follows for a $1,000 zero-coupon bond face
value:

Column 4 in the table above shows the zero-coupon bond values today (t = 0) that can be computed
from the spot curve (e.g., $1,000 / (1 + 0.036)2 = $931.71 for the first bond). Given the position values
from above for each of the three bonds, the number of bonds can be computed as shown in Column 5.
When we recompute the bond values using the implied future spot rate curve, we obtain the values
shown in Column 7 (e.g., $1,000 / (1 + 0. 0.042) = $959.66 for the first bond). The new position values
and profit/loss on each position can then be computed and are shown in the last two columns. The
table demonstrates that if the yield changes implied by the forward rate (and thus by the implied
future spot rate) are subsequently realized, then our self-financing barbell–bullet trade earns a zero
return—that is, it breaks even.

In this sense, the forward curve and the implied spot rate curve can be viewed as break-even
conditions for a trade as well as a cheapness indicator.

If the implied change of the yield curve necessary for a trade to breakeven is historically wide, the trade
can be considered expensive and vice versa.

Exercise
1. Choose the answer below that best describes the relative location of the different yield curves for an
inverted spot rate curve—i.e., the spot rate curve is sloping downward.

C is the correct answer. If the spot rate curve is inverted, the forward rate curve lies below the spot
rate curve, which lies below the par yield curve. As forward rates represent the marginal reward for
 extending the maturity by one period, they magnify any variation in the slope of the spot curve (i.e.,
they will always be less than the corresponding spot rates). In contrast, spot rates are computed as the
product of the corresponding one-period forward rates. They measure the average return from today
until a cash flow is received, so they will be higher. In turn, par yields are averages of different spot
rates. Therefore, the par curve is the flattest of the three yield curves and thus lies above the spot and
forward rate curves if the spot rate curve is inverted.
2. Suppose investors perceive longer-term bonds as higher risk than short-term bonds and thus they
require a higher yield on those securities as a risk premium. In that case, choose the best statement
regarding forward rates as break-even rates?

A is the correct answer. The fact that forward rates are break-even rates does not depend on
assumptions, such as expectations, risk premia, or convexity bias. If forward rates are realized, all
positions earn the same holding return and all self-financed positions earn a zero return.

3. Can forward rates be used in an informal way to spot cheap maturity segments?

B is the correct answer. As forward rates represent the marginal reward for extending the maturity by
one period, they magnify any variations in the spot rates. Therefore, they can easily be used in an
informal manner to visually identify cheap maturity segments in a yield curve graph as they magnify the
cheapness/richness of different maturity segments. To see this, enter the following spot rate curve on
the Excel spreadsheet as an example:
 As you can see, this spot curve is almost flat. The forward rate curve indicates, however, that the 10-
year maturity is relatively cheap. An investor could exploit this local cheapness by buying a bond that
matures in 10 years from today and selling a bond that matures in 9 years.

4. Suppose two-year and three-year spot rates are currently 6% and 6.5%, respectively. Based on that
information, compute the one-year forward rate one year from now.

5. Suppose the current spot rate curve is as follows:

Suppose you expect the spot rate curve to steepen between the four-year and the six-year maturity
over the next year and you plan to capitalize on your yield curve view by entering a barbell–bullet
position using zero-coupon bonds with initial maturities of three years, five years, and seven years.
Choose the answer that best describes how to set up this trade.

B is correct. To capitalize on your view using a barbell–bullet trade, you would sell equal market
values (say $500,000) of the three-year and seven-year zeros and use the proceeds (i.e., $1 million)
to buy the five-year zero so that the overall position is duration neutral—that is, its value won’t
change if the spot curve shifts in a parallel manner.
Full Valuation Approach: Effective Duration/Convexity and Key Rate Durations
Introduction
- Explain how effective duration and convexity are computed and interpret these risk measures.
- Explain the advantages of the full valuation approach.
- Discuss the differences between modified duration and effective duration (elasticity) and their
usefulness for different bond structures.
- Explain the differences between historical and implied interest rate volatility.
- Show the effect of changing volatility on embedded option prices.
- Explain and interpret key rate durations and show how they are computed and used in portfolio
management.
Overview of Effective Duration and Convexity (Full Valuation Approach)
You are probably using duration and convexity measures on a daily basis. However, have you ever asked
yourself: Which type of duration is most appropriate for different types of securities and what are its
limitations?

- Duration: measures the price sensitivity of a bond for parallel interest rate movements. For example, in
duration the entire yield curve is assumed to shift by a given amount, such as 25, 50, or 100 basis
points.
- Modified duration measures bond price changes for very small shifts in its yield to maturity. Modified
duration or effective duration or elasticity can be computed using any sensible yield curve shift that the
user specifies. The yield curve is shifted up by a certain amount, say 100 basis points, and down by the
same amount, then bonds are valued in the shifted case scenarios to arrive at present value prices. The
duration is then computed as a price elasticity or sensitivity to shifted yield curve scenarios.
- To value bonds with embedded options in this way, an interest rate model needs to be used. An interest
rate model is a probabilistic description of how interest rates can change over the life of a bond, making
certain assumptions about interest rate behavior. Binomial interest rate trees are most commonly used
for this purpose.

Binomial Interest Rate Trees and Bond Price Trees

Binomial interest rate trees model how short-term interest rates change over time. Given an interest rate as
well as an interest rate volatility assumption, the binomial model assumes that interest rates can realize one
of two possible states over a given interval of time. By breaking up the time to maturity of a bond into shorter
time intervals (such as one year or half a year), the interest rate behavior over the life of the bond can be
modelled using a binomial interest rate tree. The following is an example of such a tree:

If the steps in the tree are annual, then this interest

rate tree could be used to value a bond with a four-
year maturity and annual coupon payments. Here
the current one-year rate is 5.00%, and according to
the interest rate model used, the one-year rate could
either increase to 6.24% or decrease to 4.18% over
the next year, and so on. Again, the values in the tree
are based on the current yield curve as well as the
interest rate volatility assumption to generate
possible future interest rates.
 Once an interest rate tree has been generated, the
next step is to construct a bond price tree by using
the interest rate tree.

Example of a bond price tree:

The bond price tree is constructed by

successively discounting the bond’s par
value and coupon payments using the rates
from the interest rate tree and allowing for
any embedded options.
Note: A full description of different interest
rate models that can be used to price bonds
with embedded options is beyond the scope
of this text, and most fixed-income
practitioners do not need to know all the
details and assumptions behind these
models, because they are generally provided
by standard commercial packages. As a
result, we take the interest rate model as
given and describe how it is used in order to
compute effective durations / convexity
metrics and key rate durations.
Mechanics of Full Valuation Approach
How to calculate effective duration for full valuation
As described in the binomial interest rate tree section, interest rates are shifted by a certain amount and
bonds are subsequently revalued under these different scenarios to come up with the effective duration or
elasticity.

The formula is as follows: Step 1: Using an interest rate model based on

To obtain each of the bond values required when the a yield curve obtained from on-the-run
yield curve is shifted, we need to go through the following government bonds,
steps each time: - Obtain the estimated bond value
- Then compare the estimated bond value to
its market price and determine the spread
that needs to be added to each spot rate in
the interest rate tree so that the estimated
bond value equals its market price.
- This yield spread is called the option-
adjusted spread (OAS). We describe how
the OAS is computed in module 5. Here we
will simply take it as given.
Step 2: Shift the yield curve up/down by the
As you can see, the bond has to be revalued each time desired amount (e.g., 50 basis points), and for
the yield curve is shifted. There is no shortcut to this each shift, construct a new binomial interest
requirement. Therefore, this approach of coming up with rate tree.
a duration measure is called the full valuation approach. Step 3: Add the OAS to each rate in the
binomial rate tree and use the resulting
adjusted tree to value the bond in a
corresponding bond price tree.
Contrast the full valuation approach with the modified duration approach.
Unlike the full valuation approach, modified duration can be computed using just one formula without
having to revalue a bond. This may appear to be a disadvantage of full valuation. However, the full
valuation approach is actually a lot more flexible than modified duration, because it can be applied to
many different types of fixed-income securities: option-free bonds, callable bonds, putable bonds,
different types of mortgage structures, and so on.

In addition, modified duration cannot be used for security types in which cash flows change depending
on the level of interest rates.

For example, consider a callable bond with a 7% coupon and a call price of $105. The issuer of the bond
has an incentive to redeem or call the bond if interest rates decrease enough so that the bond price
increases above its call price (the $105). Once the bond is called, its owner will obviously not receive any
further coupon payments.

Therefore, we can describe a callable bond, from the investor’s point of view, as: "Callable bond = Non-
callable bond – Call option value". Hence, the bond’s cash flows and the timing of its cash flows depend
on the level of future interest rates and the probability of different interest rate scenarios that are driven
by volatility assumptions.

Volatility Assumption
- To come up with a realistic interest rate volatility assumption, investors use either historical volatilities
or implied volatilities.
 Historical volatilities are simply computed as the standard deviation of a historical interest rate series
over a given time period.
 Implied volatilities are obtained by taking market prices of traded options (interest rate caps, floors,
options on interest rate swaps, etc.) and solving for the implied volatility given an option pricing model.
- An advantage of the implied volatility approach is that it generates forward-looking volatilities as
opposed to past volatilities, which are obtained from the historical volatility approach.
- Although modified duration is very similar to effective duration for option-free bonds (especially if the
embedded options are far out of the money), modified duration cannot deal with options and would
thus give unreasonable values if applied to bonds with embedded options.

Callable Bond Example Using the Spreadsheet

The accompanying spreadsheet is mimicked below to familiarize you with its functions. However, if you desire,
you may download the spreadsheet and open it in Excel. We recommend that you then follow the steps
outlined below.

Mini-Module 2 Final.xlsm

Step by Step

Step 1: Make the following selections

using the drop-down menus in the
first three input boxes as seen in
Figure 1.
For now ignore the differences
between different choices in each
drop-down menu. Also, ignore input
boxes not mentioned in these steps.
Step 2: Now enter the values seen in
red in Figure 2. The mimicked
spreadsheet will only allow you to
enter the correct values.

Step 3: Enter the following spot rate

and annualized volatility curve in
order to construct the interest rate
tree. In the mimicked spreadsheet
you will only need to enter the Spot
Rate and Volatility in row 18 as seen
in Figure 3.

Step 4: Once you have made all these

inputs, press the “Build Tree” button
to compute the effective duration,
modified duration, and other results.
Step 5: 5.
You should see
the results
displayed in
Figure 5.

The option-adjusted spread (OAS) will be a function of a bond’s market price as well as the inputs used to
construct the interest rate tree. However, for now, we just specify the OAS as a user input. The last input
means that the call option on the callable bond starts two years from now. That is, the issuer won’t be able to
call / redeem the bond within the next two years.
Note that the option-free bond value won’t be affected by the interest rate volatilities (verify this when you
use the actual Excel spreadsheet), only the callable bond. Its embedded call option is going to be more valuable
to the bond issuer the more volatile interest rates are. As a result, the callable bond value will be lower.
Analysis of Callable Bond Example Using the Spreadsheet
Objective: After this lesson, the learner will be able to compare bond options using the analysis of callable
bonds.
- Now, let’s compare the last two values in the first numerical row (circled in red below). The effective
duration for the option-free bond is 7.19 while its modified duration is 7.11. A relatively small
difference that simply comes from the fact that modified duration assumes a very small yield change
and the effective duration was computed using a 50 basis point up and down yield shift, so it is picking
up some positive convexity.
Using the Excel spreadsheet, you can check for yourself that the difference between the two values decreases if
you use smaller yield shifts.

- As you can see from the last value in the second numerical row (circled in red below), the effective
duration of the callable bond is much smaller, only 5.31. This is because the issuer will have an
incentive to call the bond once interest rates have decreased sufficiently (and refinance their liabilities
at lower rates) to push its price above the call price of $105. Further decreases in interest rates will not
affect the bond price anymore, because it will have been called and redeemed by that time. As a
result, the callable bond’s effective duration or interest rate sensitivity is lower.
As you can see, the down and up elasticities are different. Why is that the case? The reason is: convexity.

Convexity
Objective: After this lesson, the learner will be able to describe the effect of convexity on bonds.
- Convexity arises because the relationship between interest rates and bond prices is not linear.
Convexity measures the curvature of this relationship.
- Option-free bonds increase more in price for a given interest rate decline than they fall for the same
interest rate increase. This is positive convexity, which is a desirable property for investors.
The down elasticity (7.35) is larger than the up elasticity (7.02), i.e., the option-free bond price increases more
for falling interest rates than it decreases for interest rate rises. This results in a positive convexity of 33.67 shown
in the third numerical row.

The opposite is the case for callable bonds when embedded options are deep in the money. As you will remember
from our earlier analysis, callable bonds will be called if interest rates decrease below a level that causes the
bond value to exceed the call price. Therefore, if interest rates decrease, the callable bond price will not increase
as much as the option-free bond price, resulting in a lower down rate elasticity. This can be seen in the above
results: the down rate elasticity (5.10) is lower than the up rate elasticity (5.52). The effective convexity of the
callable bond is negative (–42.08).

This convexity pattern can be seen from the bond price / yield relationship for option-free and callable bonds,
which is shown in the following graph. The callable bond price gets capped out at the call price as rates fall 200
basis points.

Effective Convexity and Full Valuation Summary

Objective: After this lesson, the learner will be able to compute effective convexity and full valuation.
The effective convexity is computed as follows:

In this way, it measures the curvature in the price/yield relationship for different types of bonds.

In general, the full valuation approach, which we use here, is used to come up with an elasticity for any desired
yield curve shift. Effective duration and effective convexity are just special cases of elasticities that can be
obtained using the full valuation approach. Both are obtained using parallel shifts to the yield curve.
- Effective duration measures the relative bond price change for a parallel yield curve shift
- Effective convexity measures the curvature in the price/yield relationship
That is, it measures how much the effective duration changes between an upward shift and a downward shift
in the yield curve.
Effective duration/elasticity already encompasses effective convexity because the bond price change for a
parallel yield curve shift is affected by the convexity in the price/yield relationship. Nevertheless, to gain a
better understanding of the price dynamics of a bond, it is useful to break out the convexity component and
look at it separately from effective duration/elasticity.
Full Valuation Approach Summary:
- Modified duration, although computationally convenient, can only be used for option-free bonds.
- The full valuation approach is much more flexible and can be used for any type of bond.
- Any type of elasticity can be computed using the full valuation approach and any desired yield curve
shift.
- Effective duration and effective convexity are the most commonly used special cases of elasticities.
Both are computed using parallel yield curve shifts.
Key Rate Durations
Objective: After this lesson, the learner will be able to define the key rate duration and state how it can be
used by portfolio managers to manage risk.
Effective duration is a bond’s price sensitivity to parallel shifts in the yield curve. Although yield changes across
different points of the yield curve tend to be highly positively correlated, they will generally not be the same.
Hence, the yield curve is unlikely to shift in a parallel manner.
- In a bond portfolio, a particular portfolio duration can be achieved using various different sensitivities
to the short, medium, and long end of the yield curve.
 To effectively manage a portfolio’s interest rate risk, the manager needs to be able to measure the
portfolio’s sensitivity to non-parallel shifts in the yield curve. This is done using key rate durations
(KRDs).
 KRDs measure a bond’s (or a portfolio’s) price sensitivity to a yield shift at one particular point on the
yield curve examined in isolation.
A KRD is computed by shifting a specified key spot rate by a certain amount (for example, 50 basis points) while
leaving all other spot rates unchanged. Hence, the steps to compute a KRD are exactly the same as for the
effective duration: the only difference is that only a portion of the yield curve is shifted while the rest of the
curve is held unchanged.

Because only one key rate is shifted at a time to compute a KRD, it can easily be seen that the sum of these
“partial” durations has to equal a bond’s effective duration. As a result, KRDs decompose a bond’s effective
duration into its component parts thereby providing portfolio managers a more detailed picture of their
portfolio’s interest rate sensitivity to non-parallel yield curve shifts.
Key Rate Duration (KRD) Spreadsheet Example
Objective: After this lesson, the learner will be able to use the accompanying spreadsheet to compute the key
rate duration.
Let’s look at a KRD example
in the accompanying
spreadsheet. To compute a
KRD, select “Key Rate
Duration (KRD)” in the
second input box:
In the next few input boxes,
make the following
selections:

In this way, we only shift the 5-year spot rate up and down by 50 basis points. By specifying a lower boundary
of 4 years and an upper boundary of 6 years, we keep all spot rates up to and including the 4-year spot rate
unchanged as well as all spot rates corresponding to maturities of 6 years and beyond. Instead of these, we
could have chosen a wider boundary.
For example, we could have specified “3 years” as the lower boundary and “7 years” as the upper boundary. As
a result, not only the 5-year rate would have been shifted but also the 4-year and 6-year rates in a proportional
manner.
- The following chart shows the yield curve shift that we have specified graphically:

If you leave all other inputs unchanged and press the “Build Tree” button

the following results are obtained:

As you can see in the column labelled “Total”, the KRD is 0.24 for the option-free bond and 0.19 for the callable
bond. This is the relative price sensitivity of each of the two bond types to a 50 basis point change in the 5-year
spot rate. As all other maturity segments of the yield curve are assumed to remain unchanged, the KRD is
considerably smaller than the effective duration we computed earlier and may be interpreted as a “partial”
duration. At this point, you may want to verify that all the individual KRDs add up to the effective duration.
Analysis of Key Rate Durations (KRDs)
Objective: After this lesson, the learner will be able to describe how KRDs can help in this case to find those
bond issues with particularly high sensitivities to the desired segments of the yield curve maturity spectrum.

In general, KRDs are particularly informative for bonds with embedded options. Consider the callable bond in
the accompanying spreadsheet.

- Uses of KRDs include hedging applications, matching portfolio interest rate sensitivities to those of a
benchmark, and the construction of trading strategies used to exploit yield curve views that a portfolio
manager may have.
- Because a bond portfolio manager’s performance is typically measured against some benchmark index,
the manager has an incentive to reduce sources of risk that he does not expect to be compensated for
relative to his benchmark. By matching his portfolio’s effective duration with the benchmark, he will only
be protected against parallel yield curve shifts but not against shifts that are different for different
maturities. A KRD analysis helps uncover certain structural mismatches between the portfolio and the
benchmark that are not readily identified by using more crude summary measures, such as effective
duration only.
- Although it is unlikely that only certain key rates change and all other spot rates remain exactly the same,
comparing KRDs between a portfolio and its benchmark helps find maturity sectors where duration
mismatches exist, which the portfolio manager can subsequently address by restructuring his portfolio.
- In addition, KRDs can be used to optimally construct yield curve trades. Suppose a portfolio manager
expects the yield curve to steepen. He would like to adjust the weights of different bonds in his portfolio
to be able to capitalize on his view if it materializes. KRDs can help in this case to find those bond issues
with particularly high sensitivities to the desired segments of the yield curve maturity spectrum. We will
discuss these kinds of trading strategies in more detail in Module 3.

Exercise
1. Suppose you are given the following information: The yield curve is shifted up and down by 100 basis
points; A bond has an original bond value of 101.13, a value of 104.45 if yields are shifted down, and a
value of 98.56 if yields are shifted up. What is the bond’s effective duration?
 B is correct. The effective duration is computed as follows:
effective duration = (104.45 - 98.56) / (2 × 101.13 × 0.01) = 2.91

2. Which of the following is a true statement? Modified duration ...

3. Which of the following is a true statement? Key rate durations ...

B is the correct answer. Key rate durations measure the price sensitivity of a bond to a shift in a specific
key rate chosen by the user with all other rates along the yield curve remaining the same. The sum of
all the key rate durations for different maturities equals the effective duration. Hence, key rate
durations decompose the effective duration into price sensitivities to specific segments of the yield
curve.

4. Using the inputs specified below, compute the effective duration and convexity of the callable bond.
 After you have computed the effective duration and
convexity, increase the callability start by three years,

and then recompute the effective duration and

convexity.

Which of the following is true?

The callable bond’s ...

A is the correct answer. The callability of the bond starts later, so its effective duration increases because it will
be more sensitive to interest rate changes and more similar to the option-free bond. In the original scenario,
the effective convexity is negative due to the call option. Because the callability will be more “restricted” if the
callability starts later, the effective convexity increases (i.e., it becomes less negative and closer to the
convexity of the option-free bond).
Yield Curve Trades: Computing and Decomposing Expected Returns

Objectives
After this module, the learner will be able to:
- Explain the importance of thinking in terms of expected returns rather than just yields.
- Outline how expected returns can be decomposed.
- Explain the benefits of the expected return decomposition and any uncertainty associated with
estimating the individual components.
- Explain how volatility affects expected bond returns.
Expected Returns on Bond Positions
Objective: After this lesson, the learner will be able to state why it is important for a portfolio manager to
compute the expected return and yield of bond positions.
- Fixed-income portfolio managers and traders tend to have views on the likely future changes in the
yield curve. They attempt to capitalize on those views by trading accordingly, for example, they might
use a barbell–bullet trade.

- As we will see in this module, only observing yields and yield spreads ignores a number of additional
sources of return. Hence, an investor should care about expected returns rather than only yields.

- In order to compute the expected return of a trading strategy and a corresponding bond position, a
portfolio manager can simply revalue his bond position under the expected yield curve scenario at the
end of his strategy/investment horizon. He can then compute the change in the value of his bond
position given his expected change in the yield curve.

- However, in addition to the total expected return that can be computed in this way, it is useful to
examine the different sources of expected returns. In other words, the manager is able to divide return
expectations into their individual components.

Decomposing Expected Returns

Objective: After this lesson, the learner will be able to explain how and why to divide expected returns into
component parts.
One of the benefits of dividing expected returns into various components is that if a portfolio manager’s view
changes, he is able to pinpoint exactly how this change will affect his expected return. Moreover, this
decomposition allows us to divide the expected return on a bond position into a component given an
unchanged yield curve (a useful base case) and a component resulting from a portfolio manager’s yield view
relative to an unchanged yield curve. The decomposition should thus help investors to better understand their
own investment positions and any implicit bets that are reflected in their position.
Following is how the expected bond return can be decomposed into various components:

The yield income is simply the income that an investor receives from coupon payments relative to the bond’s
price. Hence, it is equal to a bond’s current yield times the strategy horizon (h). So we have
The return on reinvested income is the return that can be earned by reinvesting coupon payments at a bond’s
yield to maturity. Therefore, we have

where yn is the bond’s yield to maturity with the bond maturing in n years from now. This relationship assumes
that we invest in a bond right after its coupon has been paid, so that the first coupon a bondholder receives
would be paid a year after he invests in the bond.
Rolldown Return
Objective: After this lesson, the learner will be able to describe rolldown returns and how to calculate them.
If the yield curve was certain to remain unchanged over the investment horizon, then an investor’s total
expected return would be the yield income plus the return on reinvested income plus the rolldown return.
The rolldown return is simply equal to the bond’s percentage price change resulting from an unchanged yield
curve over the strategy horizon h. Thus the bond has to be revalued at the end of the strategy horizon
assuming that yields don’t change. Then the rolldown return is

Value of Convexity
Objective: After this lesson, the learner will be able to describe the value of convexity and how to compute it.
The value of convexity comes into play if the yield curve is not constant but changes over time in level and
shape. The higher the interest rate volatility, the higher the value of convexity will be for an option-free bond.
(Note: For this analysis we will only look at option-free bonds, such as U.S. Treasury bonds.)

An investor with a long position in a bond always

benefits from convexity. If a bond has positive
convexity (cx), then the bond price will increase
more if interest rates decrease and it will
decrease less if interest rates increase than for a
theoretical bond with zero convexity.

This relationship can be seen in the following

graph.

Therefore, whatever the future path of interest rates is, the expected return of a bond with positive convexity
is going to be higher than for a zero-convexity bond. This return premium can be computed as the value of
convexity. It is computed as follows:
Yield Volatility
Objective: After this lesson, the learner will be able to describe how yield volatilities are used and the
advantages of implied volatilities.
- As yield volatilities (particularly implied volatilities obtained from options prices) are typically quoted as
relative volatilities (Vol(Δy/y)) where y is the yield and Δy is a yield change, we have to multiply the
volatility by the corresponding yield level in order to obtain the type of volatility required.
- People tend to use either historical volatilities or implied volatilities to come up with an expected
volatility.
- Historical volatilities are simply computed as the standard deviation of a historical interest rate series.
In contrast, implied volatilities are obtained from an option-pricing model. (More on this in Module 2.)
- To come up with an implied volatility, an option embedded in a bond has to be assumed to be trading
at its fair price and an option pricing model has to be assumed to be the model that would generate the
fair price. In this case, the implied volatility is the volatility that would result in the option-pricing model
producing the fair price of the option, if the implied volatility was used as an input.
An advantage of the implied volatility approach is that it generates forward-looking volatilities as
opposed to past volatilities that are obtained from the historical volatility approach.
As mentioned above, the volatility estimate obtained is generally quoted in relative terms.

Expected Return from Interest Rate View

Objective: After this lesson, the learner will be able to describe expected return from interest rate view and
explain the return composition.
- Finally, the expected return component resulting from the investor’s interest rate view is added on to
the relationship. This term would be zero if the investor expected the yield curve to remain unchanged.
This expected return component is computed as follows:

- where Dn-h is the modified duration of a bond at the end of the strategy horizon—that is, a bond with
n-h years remaining to maturity and E(yn-h) is the bond’s expected n-h-year yield to maturity h years
from now (as opposed to the current n-h-year yield to maturity that we denote by yn-h).

- We need to stress that the above return decomposition is only approximate. For example, only
duration and convexity are used to summarize the price-yield relationship and all higher-order terms
are ignored. While the expected return decomposition approximation is generally relatively precise for
zero-coupon bonds, for coupon-paying bonds, the return decomposition is more approximate,
particularly for longer-term bonds. In addition to ignoring higher-order terms in the price-yield
relationship, a different coupon reinvestment rate is assumed for different bonds as the yield to
maturity measures used implicitly assumed that all intermediate cash flows of the bond are reinvested
at the same rate, namely the yield to maturity.
-
- There is one more potential component in the expected return decomposition that we have ignored so
far, namely local richness / cheapness effects as well as potential financing advantages. Local richness /
cheapness effects are deviations of individual maturity sectors from the fitted yield curve obtained by
using some kind of curve estimation technique. As yield curve estimation techniques are designed to
produce relatively smooth curves, there will be slight deviations along the curve. In addition to that,
there will be financing advantages to certain maturity sectors in the repo market. In most cases, these
two effects tend to be relatively small, and often the two effects at least partially offset each other.
Therefore, we have not included these effects in the above expected return decomposition.
 - In general, the impact of the yield view often dominates the other components, particularly if an
asset’s duration is relatively long and the strategy / investment horizon is short.
Summary of Expected Returns
Decomposing Expected Returns Summary:

Expected returns on bond positions can be broken up into the following components:
• Yield income
• Return on reinvested income
• Rolldown return
• Value of convexity
• Expected capital gains / losses based on investor’s interest rate view

Estimating the Inputs used to Decompose Expected Returns

Objective: After this lesson, the learner will be able to describe the differences regarding yield income,
rolldown return, value convexity, and interest rate view.
There are differences regarding how easily each of the individual components of the expected return can be
measured.
- Yield Income: The expected return component that is the easiest to measure.
- Return on reinvested income and rolldown return: While still relatively straightforward to measure, it
depends on the curve-fitting technique used.
- Value of convexity: There is even more uncertainty associated with the value of convexity, which
depends on the interest rate volatility and thus the volatility estimation technique.
- Expected capital gains / losses based on investor’s interest rate view: The most uncertainty is
associated with an investor’s own personal view on future changes in interest rates. This view can be
based on purely qualitative / subjective criteria or, alternatively, on a quantitative model.
Although the quantitative approach may sound more objective, the choice of quantitative model itself remains
largely subjective, especially because a multitude of quantitative models are available that can be used.

Decomposing Expected Returns: A Practical Example

- Let’s take a look at a practical example to illustrate how the total expected return of a trading strategy
can be computed and how it can be broken up into different components.
- Suppose an investor has a barbell–bullet position in bonds with remaining maturities of 2 years, 5
years, and 10 years. The investor is long and short an initial value of $1,000,000 and his strategy
horizon is one year.
Make the following inputs in the accompanying spreadsheet to reflect this scenario:

The investor has computed the current spot rate curve, expected future spot rates, and he has obtained the
corresponding yield volatilities.
As you can see in the following graph, these inputs correspond to an expected steepening in the spot rate
curve:

Note: Remember the maturity convention we are using in the spreadsheet. Yields are aligned in “number of
years from now until maturity.” Therefore, a bond with a remaining maturity of one year at the end of the
strategy horizon one year from now will be shown as having two years from now remaining until maturity.

Analysis of Decomposing Expected Returns Example

Given these
inputs, we are
able to compute
bond prices and
other bond
characteristics
both now and at
the end of the
strategy horizon
based on how we
expect the spot
rate term
structure to
change. By
comparing
current with
future expected
bond values, we
are able to
compute total
expected returns
or expected
profits and losses
on our positions
as can be seen in
the following
table.

The total
expected return
(or expected
profit and loss)
can be
decomposed as
follows:

``
As we have weights of –0.5, 1, and –0.5 in Bond 1, 2, and 3 respectively, the total expected return of the
position computed from the individual return components is:

Total expected return = –0.5 × 3.20% + 1 × 3.05% – 0.5 × 0.46% = 1.22%

 In contrast, the
total expected
return computed
from revaluing
each of the bonds
at the end of the
strategy’s horizon
based on the
expected interest
rate scenario and
adding the future
value of the
coupon payments
(Vn-h) is:

where, for example, V1n-h is the value of the position in Bond 1 at the strategy horizon
that is the sum of the value of the bond position plus the future value of the reinvested
coupon.

As you can see, the two expected return values differ slightly. However, this difference
is expected because the return decomposition used is only an approximation.

Walking Through Return Components

Let’s now use this example to go through each of the components of the total expected return and illustrate
how it is computed. As an example, we are going to focus on Bond 2.
1. Yield income: The yield income for Bond 2 is just its current yield times the strategy horizon in years,
that is, its coupon divided by the bond price times the strategy horizon. So we have
Yield income = coupon in $ / current bond price × h = 4 / 102.79 × 1= 0.0389 or 3.89%
2. Return on reinvested income: This is the return that can be earned by reinvesting the coupon
payments at the bond’s yield to maturity. Therefore, for Bond 2 we have

where yn is the bond’s yield to maturity. This term is zero for Bond 2 because the strategy horizon is
only one year. Therefore, we get the first coupon payment only at the end of the strategy horizon,
too late to earn any return over the strategy horizon.
3. Rolldown return: As outlined earlier, the rolldown return equals the capital gains / losses that are the
result of the bond “rolling down” the yield curve over the investment horizon toward a shorter
remaining maturity. It is simply computed as the bond’s percentage price change resulting from an
unchanged yield curve over the strategy horizon h. So we have
Rolldown return = (bond pricen-h – bond pricen) / bond pricen = (101.87 – 102.79) / 102.79 = –
0.90% (≈–0.89% from expected return table; difference due to rounding)
4. Rolling yield: The rolling yield is simply the sum of the yield income, the return on reinvested income,
and the rolldown return. So we have
Rolling yield = 3.89% + 0.00% – 0.89% = 3.00%
5. Value of convexity: For option-free bonds, the curvature in the price / yield relationship of a bond is
always positive—that is, the relationship is convex. Therefore, if interest rates change, an investor
with a long position in a bond benefits from convexity (cx). The value of convexity for Bond 2 is
computed as follows:
 Note that the yield volatility (17.22%), as given in the bond value table earlier, is obtained by linear
interpolation from the volatility term structure specified by the user. It is the volatility that
corresponds to a duration of 3.78 years, which is the duration of Bond 2 at the end of the strategy
horizon (as shown in the bond value table earlier).
6. Duration impact from view (or expected return from view): This is the impact of the expected spot
rate curve change on the return of the bond position. It is computed as follows:

This information is shown graphically for all three bonds below:

Summary of Main Points

- Bond positions / trading strategies should be evaluated by examining their total expected return
rather than only yield income.
- Decomposing total expected returns allows investors to differentiate between expected returns
given static market conditions and expected returns resulting from their own yield view.
- The expected return decomposition further helps investors understand their bond position and any
implicit bets associated with it.
- However, the expected return decomposition is only an approximation and some components are
more difficult to estimate than others.

Exercise

1. Suppose you have a long position in an option-free bond. As the yield volatility across the maturity
spectrum increases, how does the expected return on your bond position change? The expected return
on the bond position...
 A is the correct answer. An investor with a long position in a bond always benefits from convexity. If a
bond has positive convexity, then the bond price will increase more if interest rates decrease and it will
decrease less if interest rates increase than for a theoretical bond with zero convexity.

2. Suppose the current spot rate curve is flat and equal to 4 percent. If you are holding a zero-coupon
bond with five years remaining to maturity and you expect no yield changes over the following year,
which of the following is a true statement? The total expected return over the following year is ...
C is the correct answer. Although you don’t expect the
yield curve to change, the value of convexity is still
positive because there is uncertainty associated with
future yield movements. Therefore, the total expected
return is larger than the yield income.

3. Which of the following is the best answer to why the earlier expected return decomposition
approximation is less precise for coupon bonds than for zero-coupon bonds? The approximation is less
precise for coupon bonds because ...

A is the correct answer. The return decomposition approximation is less precise for coupon bonds
because in order to come up with a yield summary measure for coupon bonds, a particular reinvestment
rate has to be assumed for all coupons. The most commonly used yield income measure, yield to
maturity, implicitly assumes that all coupons are reinvested at the same rate, namely the yield to
maturity. This assumption is unrealistic except when the yield curve is flat.
4. Suppose one-year and two-year spot rates are currently 6 percent and 6.5 percent respectively. Based
on that information, compute the one-year forward rate one year from now.
 What is the total expected return of the barbell–bullet strategy?
The total expected return is closest to ...
B is correct. The total expected return of the individual bonds is:

Therefore, the total expected return is:

–0.5 × 3.10% + 1 × 3.41% – 0.5 × 3.84% = –0.06%

5. Suppose you hold a long position in a bond with one year remaining to maturity. Your holding horizon
of the bond is one year. The current spot rate curve is flat and equal to 5 percent. All other inputs are
as in Question 4. What is the total expected return on the bond with one year remaining to maturity?
The total expected return of the bond is ...
C is the correct answer. In this case, the one-year bond is held until maturity so the yield income from
the bond is equivalent to the total expected return. There is no uncertainty associated with the bond
return because yields are locked in once the bond is purchased and then held to maturity.
Hedging Interest Rate Risk Using Caps and Floors

Introduction

After this module, the learner will be able to:

1. Explain how caps and floors can be used to hedge interest rate risk.

2. Outline the valuation of these instruments.

3. Explain the payoff profile of bond positions combined with caps, floors, and collars.

4. Demonstrate how zero-cost collars can be obtained.

5. Compare caps and floors with options on bonds.

6. Describe the price behavior of embedded caps and floors in floating rate securities.

Yield curve – hedging interest rate risk – mini4

1. Introduction

In many instances, a fixed-income portfolio manager may wish to protect himself against adverse interest rate
movements. For example, if he has a long position in a floating rate bond (i.e., a bond whose coupon varies
with the level of some reference rate such as three-month LIBOR), the manager may wish to protect himself
against interest rate decreases that would reduce the coupon income he receives from the bond. In contrast, if
the manager has a floating rate liability, he may want to protect himself against interest rate increases that
would increase his cost of borrowing.

Complex fixed-income securities contain embedded interest rate caps and / or floors, which investors may wish
to hedge by purchasing a cap or floor in the over-the-counter derivatives market.

A cap gives its holder a positive payoff if a reference interest rate exceeds a certain strike rate and no payoff if
it remains below the strike rate. The payoff in this case is equal to the difference between the interest rate and
the strike rate times the notional amount of the agreement.
A floor is just the opposite of a cap. It gives the holder a positive payoff if the interest rate is below the strike
rate and no payoff otherwise. Again, if there is a positive payoff, it is equal to the difference between the
interest rate and the strike rate times the notional principal of the agreement.

2. Interest rate cap and floor

Objective: After this lesson, the learner will be able to describe caps and floors and their payoffs.

Caps and floors provide the payoff at the end of each agreed period for the tenor of the cap / floor agreement.
Usually these periods are matched with a coupon payment frequency when the cap or floor is combined with a
bond position. This payoff structure makes caps / floors equivalent to packages of European interest rates
options, called caplets and floorlets, where each caplet / floorlet expires at the end of a period corresponding
to the cap / floor frequency.

Note that a cap / floor is not simply equal to one interest rate option but a package of independent options,
with the same strike rate, where each option makes a single payoff once it has been exercised and then ceases
to exist. For example, a 3-year cap on 6-month LIBOR contains six caplets. The first caplet expires in 6 months,
the second expires in 12 months, and so on. We are going to examine the relationship between caps / floors
and the corresponding caplets / floorlets more closely in the next section.
As we are dealing with packages of options whose values depend on volatility levels, we will have to estimate
interest rate volatilities again and construct interest rate trees in order to value caps and floors.

In Module 2, we outlined how either historical volatilities or implied volatilities can be used to produce a
volatility estimate. For the purposes of this discussion, we are simply going to take interest rate volatility
estimates as given. This is not because volatility is unimportant. Volatility is a key driver of interest rate option
values, and serious traders and hedgers study volatility patterns extensively in deciding when to buy and sell
interest rate options for hedging or speculative purposes. Our focus here is to look at the drivers of cap and
floor values, rather than a detailed discussion of estimating volatility, which tends to be an experience-based
art.

Valuation of Caps and Floors

Objective: After this lesson, the learner will be able to describe how caps and floors are valued and how to
calculate their value using binomial trees.

Let’s use a practical example to illustrate how caps and floors are valued. Suppose we have the following
interest rate tree, which we obtained from a term structure model as in previous modules. Binomial interest
rate trees model how short-term interest rates change over time. Given an interest rate as well as an interest
rate volatility assumption, the binomial model assumes that interest rates can realize one of two possible
states over a given interval of time. By breaking up the time to maturity of a bond into shorter time intervals
(such as one year or half a year), the interest rate behavior over the life of the bond can be modelled using a
binomial interest rate tree.

Based on this interest rate tree, we would like to value a three-year cap with a strike rate of 6 percent, annual
payment frequency, and a $100 notional amount.
The value of the three-year cap is equal to the sum of the values of the corresponding caplets, or European
interest rate options, with one of them expiring at the end of every period. So we have
Value of 3-year cap = Value of 1-year caplet + Value of 2-year caplet + Value of 3-year caplet
The corresponding cap price tree is as follows:
Cap value
Objective: After this lesson, the learner will be able to demonstrate the cap value calculations.
To compute the caplet values and the resulting cap values, we can use backward induction again—that is,
we go through the interest rate tree starting from the last period, Year 3 in this case. In Year 3, the value of
the cap is simply equal to the value of the 3-year caplet because the 1-year and 2-year caplets will have
expired by the time we get to Year 3. So, for example, the value of the cap in Year 3 at the top interest rate
node can be calculated as follows:

Note the term (1 + rate) in the denominator. This term is needed because the payoff of the cap isn’t received
until one period later. The settlement payments for caps and floors are in arrears. As a result, the cap payoff
in Year 3 doesn’t take place until the end of Year 3 or 4 years from now. Hence, the payoff has to be
discounted back one period using the appropriate interest rate.
To obtain the values of the cap one period earlier (i.e., Year 2), we need to discount the Year 3 cap values
and add the value of the 2-year caplet at that time to the discounted value. Hence, using the cap values in
Year 3 from the tree above, the Year 2 cap value at the highest node is computed as follows:

So we have

In Year 1 (i.e., one period earlier), the cap value is again obtained by discounting the appropriate cap values
from Year 2 and adding the 1-year caplet value to it. Hence, the cap value at the top node in Year 1 is

Current cap value

Objective: After this lesson, the learner will be able to describe current cap value.
The cap value calculation is repeated until we have obtained the current value of the cap. The value of a floor
is computed using exactly the same methodology. The only difference is that the payoff of the floor is
max(strike rate – rate, 0). Hence, it pays off a positive amount if the interest rate is below the strike rate
rather than above.
The price tree for a floor with a 6 percent strike rate and a notional amount of $100 based on the interest
rate tree earlier is as follows:
 For example, the floor value at the lowest node in Year 3 is computed as

Again, earlier floor values are obtained by discounting the probability-weighted sum of later floor values and
successively adding the values of the shorter-term floorlets. For example, the floor value at the lowest node
of Year 2 is computed as

Caps and Floors Combined with Floating-Rate Bonds

Objective: After this lesson, the learner will be able to describe the combination of caps and floors in the case of
floating-rate bonds.

The value of a structure that combines a floating-rate bond with a cap or floor is simply equal to the value of the
floater plus or minus the value of the cap / floor depending on whether we have a long or a short position in the
cap / floor.
If a cap or floor is combined with a floating-rate bond, the cash flows (coupon payments) from the floater can be
modified as is illustrated in the chart below:

The coupon of a “pure” floating-rate bond is equal to the relevant LIBOR reference rate at the time. So, the
relationship between LIBOR and coupon payments / cash flows is just a straight line. If the floater is combined
with a long position in a floor that has a 5 percent strike rate, the cash flows from this position are shown on the
red line.
Using a 5 percent floor, the minimum coupon rate would be 5 percent, whereas the maximum rate would still be
unlimited. On the contrary, combining a floater with a short position in a cap that has a 5 percent strike rate gives
us the cash flow profile depicted by the green line.
Using a 5 percent cap, the maximum coupon payment / cash flow for this structure would be 5 percent. So if we
hold a floating-rate bond and combine it with a short cap, we would give up the potential to earn a coupon rate
above 5 percent. However, at the same time, we would be able to collect the option premium from selling the
cap.

For the purposes of this analysis, we are assuming a floating-rate bond with no credit or prepayment risk.

Valuing Caps / Floors Using the Spreadsheet

Let’s use a practical example to illustrate this relationship with the accompanying spreadsheet.
Note: You may follow the examples below or download the spreadsheet. If you download the
spreadsheet and don't make any changes, the default values will be those described below. If you have
made changes, please re-enter the values corresponding to the example.
a. Select Spot Rates and the values as shown in Figure 1

b. Select Spot Rates and the values as shown in Figure

c. Click the Build Tree button shown in Figure 3.

d. You should get the results shown in Figure 4.
 For the moment, ignore the entry labelled “Collar Cost”. We are going to defer the discussion of collars until
the next section. As you can see for the interest rate scenario and strike rates chosen, the cost / value of the
cap is higher than the cost / value of the floor.

The floating rate bond in isolation is worth $100. If we combine the floating rate bond with a long 5 percent
floor position to protect us against decreasing interest rates below 5 percent, we need to add the value of
the floor to the value of the floater to obtain a total value of the structure of $101.57. If we combined a short
position in a cap with a floater, the value of the structure is equal to the value of the floater reduced by the
value of the cap, resulting in a total value of $96.18.

Combining Caps and Floors – Collars

Objective: After this lesson, the learner will be able to describe collars and reverse collars.
Market participants with a floating-rate liability often combine caps and floors into a collar by buying an
interest rate cap and selling an interest rate floor with a lower strike rate. The purchase of a cap protects
against rising interest rates, and its purchase price can be wholly or partially offset by the sale of an
interest rate floor. By selling an interest rate floor, however, the borrower gives up any interest rate
savings that could otherwise have been obtained if the reference rate falls below the floor strike rate. In
this case, the seller of the floor has to make a payout to the buyer equal to the difference between the
interest rate and the strike rate.
As a result of the collar, the net interest rate a borrower has to pay is restricted to the range between
the floor and the cap strike rates. Therefore, his interest rate risk is reduced. The following graph shows
the cash outflows of a floating-rate borrower who has a short position in a floating-rate bond or a short
floater combined with a long collar, with strike rates of the cap and floor of 6 percent and 4 percent
respectively.

If the cap and floor strike rates are the same, all the interest rate uncertainty has been eliminated. In
that case, the short position in the floating-rate bond plus the collar is equivalent to a short position in a
fixed-rate bond. Or, equivalently, a long position in a floater combined with a short position in a collar
(called a reverse collar) is the same as a long position in a fixed-rate bond. Therefore, the value of the
combination of the floating rate bond and the collar has to equal the corresponding fixed-rate bond
value.

To check this relationship, use the same inputs on the Excel spreadsheet as earlier, but set both the cap
and the floor strike rates equal to 6 percent so that they are in line with the fixed-rate bond coupon of
$6.
1. Set cap and floor strike to 6% as in Figure 1.
2. Click the Build Tree button shown in Figure 2.
 3. As shown in Figure 3, you should see in the last two rows of the results table that the value of the
long floater plus reverse collar combination equals the fixed-rate bond value.

This result is because by selling a floor and buying a cap both with the same strike rate, we have
eliminated any uncertainty with regards to the cash flow / coupon we receive from the structure. In
the example above, the cash flow is always going to be 6 percent regardless of the level of the LIBOR
reference rate. Hence, the structure has exactly the same payoff as a fixed-rate bond with a $6 (or 6
percent) coupon. Therefore, its value has to be the same as well.

A collar is a way of obtaining interest rate protection for a borrower in a cost-efficient way.

From a bondholder's (or lender’s) perspective, we can obtain interest rate protection using a reverse
collar as shown above. A reverse collar involves combining a short position in a cap with a long
position in a floor. This combination guarantees a minimum coupon rate equal to the strike rate of
the floor. By giving up the potential to earn a coupon rate of more than the cap strike rate, we are
able to obtain interest rate protection in a cost- efficient way. Shorting the cap (partially) finances
the floor purchase.

Floating-Rate Bonds Containing Embedded Caps and Floors

Objective: After this lesson, the learner will be able to describe floating rates and capped floaters, and
their effect on value structures.
Floating-rate bonds are often structured with a coupon rate that is capped at a certain level or a floor is
placed on their coupon rate. Sometimes a security contains both a cap and a floor.

Capped floaters are equivalent to a combination of a long position in a floater and a short position in a
cap. A capped floater has a lower value than a “pure” floater because its coupon rate is limited to the
cap rate. Therefore, its value is equal to par minus the value of the cap. In other words, an investor in a
capped floater would be able to obtain a “pure” floater by buying back the cap that he has implicitly
shorted. The price discount for the capped floater is compensation for the investor because he is going
to receive below-market yields if the LIBOR reference rate rises above the cap rate. At this point a
floater becomes like a fixed-rate bond because its coupon rate no longer fluctuates.

Similar reasoning applies to floaters that come with a floor-rate protection. For an investor in these
structures, they are equivalent to a floating-rate bond combined with a long floor. Therefore, a floater
with floor-rate protection has a value above par. Its value is equal to the “pure” floater value (i.e., par)
 plus the value of the floor. If the LIBOR reference rate falls below the floor, then the floater with floor-
rate protection becomes like a fixed-rate bond because its coupon rate no longer fluctuates.

Some floaters are both capped and have a floor rate. Hence, they are equivalent to a “pure” floater
combined with a reverse collar (or short collar). Therefore, this type of structure only retains floating-
rate bond characteristics as long as the LIBOR reference rate is between the floor and the cap rate,
otherwise the structure’s characteristics will be more similar to a fixed-rate bond.

The values of these different structures are shown in the following graph. Using the interest rate and
volatility scenario from earlier, we shift the spot rate curve up and down in a parallel manner using 50
basis point increments. Under each rate shift scenario, we record the values of a “pure” floating-rate
bond, a fixed-rate bond, as well as a capped floater with a 6 percent cap, a floater with a 5 percent
floor, and a floater with both a cap and a floor.

The graph shows that as interest rates decline, the capped floater’s value is very similar to the floating-
rate bond’s value because the cap is out of the money. As interest rates increase, the capped floater
becomes like a fixed-rate bond and, therefore, has a similar value. The floater with a floor becomes
very similar to a “pure” floater when interest rates increase and, therefore, has a similar value. As
interest rates decrease, the floater becomes more similar to a fixed-rate bond and its value approaches
the fixed-rate bond value.

Zero-Cost Collars
Objective: After this lesson, the learner will be able to show how zero-cost collars are obtained using
the spreadsheet.
A collar that is often of particular interest is the so-called zero-cost collar. For a zero-cost collar, the cap
and floor strike rates are chosen in such a way that the values of the cap and the floor are equal.
Therefore, by selling the floor and buying the cap, a floating-rate borrower is able to obtain some
protection against interest rate increases at zero cost.

Numerical procedures can be used to solve either for the floor strike rate, given a desired cap strike
rate, that results in a zero-cost collar or for the cap strike rate, given a desired floor strike rate, that
produces a zero-cost collar.
Let’s take a look at a practical example. Use the earlier example again in which we had the following
inputs:
Analysis of Zero-Cost Collar Example
Objective: After this lesson, the learner will be able to analyze the zero-cost collar using the
spreadsheet.
The cost of the cap exceeds the cost of the floor. Therefore, the cost of the collar is positive. To
produce a zero-cost collar, we could either solve for a floor strike rate that, for a cap strike rate of 6
percent, makes the collar costless or we could solve for the cap strike rate that, for a floor strike rate of
5 percent, makes the collar costless.
Let’s try both approaches. First, leave the cap strike rate at 6 percent and solve for the floor strike rate

that produces a zero-cost collar by pressing the button …

You should see the following result …

Now, reset the floor strike rate to 5.00% and then press the button …
You should see the following output …
Hence, if you wanted protection against rising interest rates exceeding a strike rate of 6.00 percent,
you would be able to obtain this type of protection at no cost if you combine your cap purchase with
selling a floor with a strike rate of 5.66 percent. Therefore, the price you pay for the protection against
rising rates is offset by giving up the lower borrowing costs that would result if interest rates fell below
5.66 percent.

Alternatively, if you wanted to benefit from potential interest rate decreases down to a level of 5.00
percent, you would have to accept interest rate increases up to 7.05 percent if you wanted to obtain
costless protection. Better interest rate protection can only be obtained by paying a positive amount
for the collar or by giving up more interest rate savings if interest rates decline.
Caps and Floors vs. Options on Bonds
Objective: After this lesson, the learner will be able to compare options on bonds with caps and floors.
Caps and floors, as packages of interest rate options, are very similar to options on bonds. Both types of
options are influenced by interest rates. The important difference between these two option types is,
however, that the value of caps and floors depends directly on the level of the interest rate, whereas
the value of options on bonds depends on the bond price that, in turn, is affected by interest rates. As a
result, the values of each type of option move in different directions as interest rates change.

This can be summarized as follows:

 Therefore, buying a cap is equivalent to buying a package of puts on a bond, and buying a floor is
equivalent to buying a package of calls on a bond.
3. Summary
Fixed-income market participants are able to protect themselves against adverse interest rate moves
by using caps and floors. Caps pay out a positive amount if the reference interest rate exceeds their
strike rate, and floors pay out a positive amount if the reference rate falls below their strike rate.
Combined with floating-rate bond positions, they provide interest rate protection. However, they can
also be combined with a fixed-rate bond to allow the holder to benefit from rising interest rates or the
savings provided for a borrower from falling interest rates.

To provide interest rate protection at a lower cost, caps and floors are often combined in a collar or
reverse collar in which shorting one component (cap or floor) partially or fully offsets the cost of the
component (cap or floor) that is purchased.

As we have seen, caps and floors, as options on interest rates, are equivalent to packages of options on
bonds, which are options on bond prices that are, in turn, affected by interest rates.

Questions:
a. Suppose the interest rate volatility increases. How will this increase affect the value of a cap and a
floor?
Since caps and floors are packages of interest rate options which provide a limited downside to the
option holder and almost unlimited upside potential, their value always benefits from increasing
volatility as the chance of a large payoff that the option holder receives is increased but his downside
remains limited.
b. Again, suppose the interest rate volatility increases. How will this increase affect the cost of a collar
that was a zero-cost collar in the original volatility environment? The value of the collar … A zero-cost
collar is a combination of a short position in a floor and a long position in a cap that is self-financing, i.e.
the value of the floor sold short is equal to the value of the cap purchased. We know from Problem 1
that the value / cost of a cap and a floor increases if interest rate volatility increases. However, the
relative magnitude of the increase depends on the characteristics of the cap and the floor as well as on
the interest rate environment.
c. Suppose you have a long position in a fixed rate bond with a 6% coupon and ten years remaining to
maturity. You would like to use a cap and/or a floor in order to convert this position to a long position
in a floating rate bond. What would be the cost of this under the following scenario for a $100 notional
amount?
 Making these inputs in the accompanying spreadsheet and pressing the “Build Tree” button yields a
floating-rate bond value of $100 and a fixed-rate bond value of $101.46. Therefore, the short floor
position produces more option premium than the long cap position costs, and the collar has a negative
rather than a positive cost. Whether the collar produces income or costs money depends in part on the
relationship between the coupon rate and interest rates.
In order to convert the long position in the fixed rate bond to a long position in a floating rate bond, a
collar has to be purchased with both the cap and the floor strike rate equal to the fixed rate bond
coupon rate, in this case 6%. Once you make these inputs on the accompanying spreadsheet and press
the “Build Tree” button, the results table shows a cost for the collar of –$1.46, i.e. you would get paid
by entering this agreement. This is because the floating rate bond has a lower value than the fixed rate
bond which can also be seen from the results table. The floating rate bond value is $100 and the fixed
rate bond value is $101.46, a difference of –$1.46.

d. Suppose you are a borrower paying a fixed borrowing rate of 6% on a notional amount of $100. Since
you expect interest rates to decrease, you would like to benefit from the expected decrease by
lowering your borrowing costs. Which type of transaction (and at which cost) would be able to achieve
your objective under the same scenario as in Problem 3?
A long position in a floor gives you a positive payoff if interest rates fall below its strike rate. Therefore,
buying a floor allows you to benefit from falling interest rates. Under the scenario from Problem 3, we
obtain a floor cost of $5.27 using the accompanying Excel spreadsheet.
Buying a cap gives its holder a positive payoff if interest rates rise above its strike rate. Therefore,
buying a cap does not provide a benefit to the borrower if interest rates fall.
Buying the collar involves purchasing a cap to protect against rising interest rates and selling a floor. By
selling a floor (rather than buying a floor), the borrower gives up any interest rate savings associated
with a fall in interest rates below the floor strike rate.
e. Using the same inputs as in Problem 3 above, a floating rate borrower would like to obtain interest rate
protection on a notional amount of $100. He would like to avoid paying a borrowing rate of more than
6%. How could he achieve his objective at zero cost?
Yield Curve − Option-Adjusted Spreads
mini file 5

After this module, the learner will be able to:

1. Explain intuitively how option-adjusted spreads (OAS) and other spread measures are computed.

2. Outline in which circumstances each measure is used appropriately.

3. Explain how OAS depend on the interest rate volatility estimate and embedded option characteristics.

4. Explain how OAS are used for different types of securities.

5. Discuss strengths and weaknesses of the OAS concept.

1. Introduction
Corporate bonds need to offer a return premium to investors due to the existence of credit, liquidity, and
option risk. There are various ways to measure this return premium. The three most common measures are:
nominal yield spreads, zero-volatility spreads (Z-spreads), and option-adjusted spreads (OAS).

In the following, we outline the computation of each of these metrics and explain their uses. Certain types of
spreads are more appropriate than others depending on the type of bond.

2. Nominal Spreads
Objective: After this lesson, the learner will be able to explain why nominal spreads are generally not
particularly meaningful for bonds with embedded options.

For example, if a corporate bond has five years remaining to maturity and a yield to maturity of 6.5% while the
corresponding government bond with the same maturity yields 5.4%, then the nominal spread is equal to 110
basis points (6.5% minus 5.4%).

A drawback associated with this type of spread measure is that it does not take into account the term structure
of spot rates for both bonds. In other words, all cash flows are discounted using the same rate. As shown in the
graph below, the nominal spread is added to the point on the yield curve that corresponds to the maturity of the
bond being analyzed (10 years in this example). As a result, the nominal spread does not allow proper comparison
of two bonds with different coupons even if the maturities or durations are the same.
Moreover, for bonds with embedded options, changing interest rates may alter the cash flow of the corporate
bond, a fact that is ignored by the nominal spread. Generally, bonds with embedded options are callable, so in
the following we will focus on callable bonds. However, the discussion below refers to any type of embedded
option—for example, a put option in a putable bond.

If the bond issuer decides to exercise his call option, the bond holder is going to forego any further coupon
payments, which will change the bond yield (in most cases, this will reduce bond yields). Therefore, nominal
spreads are generally not particularly meaningful for bonds with embedded options.

3. Zero-Volatility Spreads (Z-Spreads)

Objective: After this lesson, the learner will be able to describe the difference between the nominal spread and
the Z-spread and when the two are actually the same.

In other words, it is the yield spread over the spot rate curve that an investor in the corporate bond would
realize. It is computed by trial and error. This type of spread is called zero-volatility spread since it implicitly
assumes that the interest rate volatility is zero, which means that the embedded option in a callable bond has
zero value since it is not exercised. Hence, in a similar way as the nominal spread above, the Z-spread assumes
that the bond's cash flows do not change with the level of interest rates. Clearly, this is an unrealistic
assumption for bonds with embedded options. As a result, the Z-spread, while useful for callable bonds as a
measure of total yield in a low volatility scenario, doesn't specifically analyze the cost of the embedded call
option.

The difference between the Z-spread and the nominal spread is the benchmark that is being used. The nominal
spread is added to the point on the yield curve that corresponds to the maturity of the bond being analyzed. In
contrast, the Z-spread is a constant that is added to each spot rate over the life of the bond analyzed.
Therefore, in the Z-spread calculation, each cash flow is discounted with a different interest rate as can be seen
in the graph below.

In most cases, the nominal spread and the Z-spread are of similar magnitude. If the spot rate curve is
completely flat, then the two spread measures are actually the same. The difference between the two
measures increases as the spot rate curve steepens.

4. Option-Adjusted Spread (OAS)

Objective: After this lesson, the learner will be able to state what interest rate models consist of, what they
commonly use to address interest rate changes over time, and how Z-spreads and OAS are related.
The OAS is computed in a similar manner as the Z-spread. In fact, one can think of it as the Z-spread that has
been adjusted for any option embedded in the bond.

For a callable bond (or any bond with an embedded option), we usually cannot compute the bond value simply
by discounting its future scheduled cash flows. Instead an interest rate model has to be used to value this type
of bond, as we have seen already in Module 2. This type of model takes into account the interest rate volatility
and the fact that the bond’s cash flows may change with the level of interest rates as the embedded option is
exercised.

In general, an interest rate model is a probabilistic description of how interest rates can change during the life
of a bond, making certain assumptions about interest rate behavior. Binomial interest rate trees are most
commonly used for this purpose.

As we have seen in previous modules, binomial interest rate trees model how short-term interest rates change
over time. Given an interest rate as well as an interest rate volatility assumption, the binomial model assumes
that interest rates can realize one of two possible states over a given interval of time. By breaking up the time
to maturity of a bond into shorter time intervals (such as one year or half a year), the interest rate behavior
during the life of the bond can be modelled using a binomial interest rate tree. The following is an example of
such a tree:

If the steps in the tree are annual, then this interest rate tree could be used to value a bond with a 4-year
maturity and annual coupon payments. Here the current one-year rate is 5.00%, and according to the interest
rate model used, the one-year rate could either increase to 6.24% or decrease to 4.18% over the next year, and
so on. Again, the values in the tree are based on the current yield curve as well as the interest rate volatility
assumption.

Once an interest rate tree has been generated, the next step is to construct a bond price tree using the interest
rate tree. Here is an example of a bond price tree:

The bond price tree is constructed by successively discounting the bond's par value and coupon payments using
the rates from the interest rate tree and allowing for any embedded options.
A full description of different interest rate models that can be used to price bonds with embedded options is
beyond the scope of this text and most fixed−income practitioners do not need to know all the details and
assumptions behind these models, because they are generally provided by standard commercial packages. As a
result, we take the interest rate model as given for our OAS analysis.

The OAS is based on an interest rate model and takes future interest rate volatility into account. Hence, it
recognizes the fact that the bond's cash flows change depending on the future path of interest rates if the bond
includes an embedded option.

Just as with the Z-spread, the OAS is computed by trial and error and is the yield spread that, if added to the spot
rate curve, equates the bond value obtained from an interest rate model with the market price of the bond. In
this sense, as opposed to the nominal spread and the Z-spread, the OAS is model dependent. Different interest
rate models used will produce different OAS values for the bond with embedded options. More importantly, the
interest rate volatility estimates used as an input to the interest rate model have a significant impact on the value
of the embedded option and thereby on the OAS.

In essence, the OAS is computed in the same way as the Z-spread. However, it accounts for the optionality in
the bond with an embedded option. Because the Z-spread does not take this into account, one could label it
the zero-volatility OAS.

Alternatively, you can think of removing or stripping the call option from the callable bond and thereby create a
hypothetical option-free bond that is otherwise equivalent to the callable bond. The Z-spread would make the
model value of the hypothetical bond equal to the callable bond's market price and the OAS makes the callable
bond value obtained from the interest rate model equal to its market price.

Hence, we have the following relationship:

Because these types of spread measures are used for corporate bonds and are computed either relative to the
government yield curve (nominal spread) or the government spot rate curve (Z-spread and OAS), they always
have to be positive. If a government benchmark is used and the resulting spreads for corporate bonds end up
being negative, then there has to be an error in the valuation model or the methodology used to compute the
spread. Corporate bonds always have higher credit risk, liquidity risk, and option risk, than default free
government bonds that are option-free bonds.

Summary of Yield Spreads

Three types of yield spreads are commonly used: nominal spreads, zero-volatility spreads, and option-adjusted
spreads (OAS). They differ in the benchmark relative to which they are computed and they reflect
compensation for different types of risk:

• Nominal spreads: computed relative to the government yield curve, reflect compensation for credit risk,
liquidity risk, and option risk.

• Zero-volatility spreads: computed relative to the government spot rate curve, reflect compensation for
credit risk, liquidity risk, and option risk.

• OAS: removes the impact of the embedded options on the bond’s Z-spread. OAS reflect compensation
only for credit and liquidity risk.

6. Yield Spreads: A Practical Example

Mini file 5
 1. Make the following inputs on the accompanying spreadsheet:

2. After you have made those entries, press the “Build Tree” button first and then the “Solve for Z-

Spread” and “Solve for OAS” buttons.

3. The above inputs cause the spreadsheet to generate the interest rate tree, price the bonds based on
that tree, and then obtain the Z-spread and OAS that make the option-free and callable bond values

equal to their market prices.

4. The resulting values are as follows:

6.Analysis of Spreadsheet Computation of Yield Spreads

Objective: After this lesson, the learner will be able to describe how volatility affects the call option and how
these affect the option-adjusted spread (OAS).
The resulting nominal yield spread for the option-free bond is 179.18 basis points. Because the nominal yield
spread cannot accommodate changing cash flows for changing interest rates, it does not make sense to
compute this measure for bonds with embedded options.

The Z-spread is 179.86 basis points, very similar to the nominal spread. The similarity between these two
metrics is expected because the spot rate curve that we used is almost flat. At this point, you might want to
experiment with the spreadsheet to see how different shapes of the spot rate curve affect the difference
between the nominal spread and the Z-spread. As the spot rate curve steepens, the difference between the
two should increase.

The Option-Adjusted Spread (OAS) for the callable bond that has the same characteristics as the option-free
bond, except for the callability, is 166.02 basis points. It is smaller than the corresponding Z-spread because for
non-zero interest rate volatilities the value of the embedded option is positive. Instead of the option value, the
yield spread that corresponds to the value of the option (labeled “Embedded Call Option Cost”), is shown in the
last row of the table below.

The embedded call option cost is 13.85 basis points, which is equal to the difference between the Z-spread and
the OAS as we have seen. So we have

It is important to emphasize again that the call option cost is heavily affected by the interest rate volatility
estimate used to price the option. Higher volatilities lead to higher option values and thus higher option costs
in yield space. From the above relation, the OAS will decrease with higher volatility assumptions.

7. Influence of Yield Volatility Assumption on OAS

Objective: After this lesson, the learner will be able to explain how a higher call strike price affects volatility
and OAS.

As we have seen in Module 2 already, people tend to use either historical volatilities or implied volatilities to
come up with an expected volatility. Historical volatilities are simply computed as the standard deviation of a
historical interest rate series. In contrast, implied volatilities are obtained from an option pricing model. To
come up with an implied volatility, an option embedded in a bond has to be assumed to be trading at its fair
price and an option pricing model has to be assumed to be the model which would generate that fair price. In
this case, the implied volatility is the volatility that would result in the option pricing model producing the fair
price of the option, if the implied volatility was used as an input. An advantage of the implied volatility
approach is that it generates forward-looking volatilities as opposed to past volatilities that are obtained from
the historical volatility approach. Other types of interest rate options that can be used to extract implied
volatilities are caps / floors and collars as well as swaptions (i.e., options that grant the holder the right to enter
an interest rate swap).

Yield volatilities (particularly implied volatilities obtained from options prices) are typically quoted as relative
volatilities (Vol(Δy / y)) where y is the yield and Δy is a yield change, we have to multiply the volatility by the
corresponding yield level in order to obtain the type of volatility required.
As a next step, increase the call strike price from $100 to $102 in cell C8 and then press the “Build Tree” button

first and then the “Solve for Z-Spread” and “Solve for OAS” buttons.

What do you see? We expect the value of the embedded option or the call cost to decrease since the bond
issuer now has to pay $102 instead of $100 to call the bond. Therefore, the call option will be less valuable to
him. The ”moneyness” of the option has been reduced. The new results confirm this expectation:

As a result of the higher call strike price, the option cost (to the bondholder) has been reduced from 13.85 basis
points to 3.97 basis points, resulting in an increase of the OAS from 166.02 basis points to 175.90 basis points.

8. OAS Analysis of Mortgage-Backed Securities

However, for MBS there is an additional step involved in addition to modeling the probabilistic behavior of
government spot rates, namely homeowners’ tendency to prepay their mortgages has to be modeled using
prepayment models. Therefore, we have an additional layer of uncertainty and the OAS is only a good measure
of value if homeowners exercise their prepayment option in a consistent and predictable manner.

Whether homeowners actually decide to prepay depends on a number of factors, not only the future interest
rate path.

• First, prepayment depends on whether it makes economic sense for them to do so, which, in turn,
depends among other things on the development of interest rates as well as a homeowner’s tax situation.

• Second, the decision to prepay depends on homeowners’ ability to refinance their mortgage at an
advantageous rate. In some cases, this might be unfeasible if, for example, their own credit situation has
deteriorated.

• Third, even if it makes economic sense for homeowners to prepay and they are able to do so, many
homeowners choose not to for personal reasons.

As a result, the decision to prepay is a lot more idiosyncratic than a corporate bond issuer’s decision to call the
bond, which is almost exclusively determined by interest rate factors. Again, the extent to which the OAS is
helpful to value MBS is highly dependent on how well prepayments can be modeled.
9. Advantages and Drawbacks of Different Yield Spread Measures
Objective: After this lesson, the learner will be able to describe the advantages and drawbacks of different
yield spreads. The following table gives an overview of the advantages and drawbacks of the different yield
spread measures discussed above:

Advantages Disadvantage
Nominal Yield Quantifies risk as implied Spread added to yield-to-maturity of bond so bonds with
Spread by the market different coupons cannot be compared

Does not accommodate any embedded options

Cannot be computed if market prices are unavailable

Quantifies overall risk of bond relative to Treasury

benchmark but cannot be used to isolate particular risk
types

Z-Spread Quantifies risk as implied
by the market
Constant spread is added
to each spot rate, so bonds
with different coupons can
be compared
Does not accommodate any embedded options
Cannot be computed if market prices are unavailable
Quantifies overall risk of bond relative to Treasury
benchmark but cannot be used to isolate particular risk
types

Option-Adjusted Quantifies risk as implied Dependent on the interest rate model used and the
Spread (OAS) by the market volatility estimates

Constant spread is added Cannot be computed if market prices are unavailable

to each spot rate, so bonds
with different coupons can Quantifies overall risk of bond relative to Treasury
be compared benchmark but cannot be used to isolate particular risk
types
Is able to accommodate
embedded options

Nominal spreads are commonly used because of their simplicity and ease of computation. Traders will often
compare comparable securities by discussing their relative nominal spreads. For more precise valuation, even
when dealing with bullet bonds, Z-spreads are technically superior.

For option-free bonds, market participants will use both nominal and Z-spreads. We have discussed why Z-
spreads are a more precise measure of spread across the entire curve, but nominal spreads are a common and
easy first step.

For bonds where options are present, market participants will look at all three spread measures discussed, but
spend more time refining their analysis of OAS. The main advantage of OAS analysis for option- embedded
bonds, is that it allows comparison across different bond structures on a risk-adjusted basis.

Theoretically, one could compare the OAS on a mortgage or asset-backed security to a non-callable corporate
bond and make some relative value judgements. In practice, portfolio managers tend to use OAS models
within sectors of the market to gauge relative value.
10. Question
a. Which of the following is a true statement? Corporate bond option-adjusted spreads (OAS) cannot be
negative because they .... OAS reflect the credit risk, liquidity risk, and option risk of corporate bonds. All three
sources of risk are larger for corporate bonds than for Treasury bonds. Hence, OAS are always positive.

b. Suppose we have the same scenario as earlier, that is

However, now the volatility term structure shifts up by one percentage point. How is the option-adjusted
spread (OAS) affected and why? The OAS ...

As the interest rate volatility increases, the value of the embedded option increases. Hence, the embedded
option becomes more valuable to the bond issuer, and correspondingly, the option cost to the bondholder
increases. Since the OAS can be computed as OAS = Z-spread − option cost, the OAS has to decrease. We have
ΔOAS = ΔZ-spread – Δoption cost = 0 bp – (18.10 bp – 13.85 bp) = – 4.25 bp.

c. Suppose you use the original scenario from Question 2, how is the difference between the Z-spread and the
nominal yield spread for the option-free bond affected when we switch from spot rates to par yields? Why
does the difference change in this way?

The difference between the Z-spread and the nominal yield spread ...

As we saw in Module 1, par yields are averages of different spot rates because they are a one-value summary
measure of a bond’s yield. Therefore, the par curve is the flattest of all yield curves and the steepness of the
resulting spot rate curve increases. As we have seen earlier, the steeper the spot rate curve, the larger the
difference between the nominal spread and the Z-spread is going to be. The two measures will be the same if
the spot rate curve is flat.

d. For the original scenario from Question 2, increase the callability start date from 2 years to 5 years from now

and then press: How does the option -adjusted spread (OAS) change? The OAS ... We
know that a later callability start date and thus a shorter life will make the call option less valuable to the issuer.
Therefore, the option cost to the bondholder will decrease. Since ΔOAS = ΔZ-spread – Δoption cost, the OAS
has to increase due to the lower option cost. From the spreadsheet we have ΔOAS = OASnew – OASold =
175.29 bps – 166.02 bps = 9.27 bps

The OAS will increase when the call date moves further into the future. A later call date reduces the value of
the call option to the issuer, which increases the bond value to the investor.

e. Which of the following is the best explanation for why mortgage-backed securities (MBS) are more difficult
to value using option-adjusted spreads (OAS) than standard callable corporate bonds? MBS are more difficult to
value because ... the decision to prepay is a lot more idiosyncratic than a corporate bond issuer’s decision to
call the bond, which is almost exclusively determined by interest rate factors.
A prepayment on an MBS is not necessarily more likely than a call on a corporate bond. The likelihood depends
on the particular security characteristics and interest rate scenario.