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DISCOUNT FACTORS
The discount factor between two dates, t and T, provides the
term of exchange between a given amount of money at t versus
a (certain) amount of money at a later date T:
The discount factor is denoted by Z(t,T)
If the Treasury issued 182-day Treasury bills at a price of Rs.97.477 for
Rs.100 of face value , it implies That is, market participants were willing
to exchange 0.97477 rupees on the first date for 1 rupee six months
later
This Treasury bill would not make any other payment between the two
dates
The ratio between purchase price and the payoff, 0.97477 =
Rs.97.477/Rs.100, can be considered the market-wide discount factor
for 6 months
DISCOUNT FACTORS
The notion of discount factor is unambiguous
while that of interest rate is not as it depends on
the compounding frequency.
Discount rates are at the heart of fixed income
securities analysis as they unambiguously
represent an exchange rate between money
today versus money tomorrow.
Compounding Frequencies
Two compounding frequencies are important:
semi-annual and continuous.
Semi-annual compounding
payment on treasuries.
matches
coupon
Discount Factor
We can derive the discount rate from the semiannually compounded interest rate.
Let r2 (t, T) denote the (annualized) semi-annually
compounded interest rate between t and T. The
2(T t )
payoff at T would be:
r2 (t , T )
Investment
at
t
Payoff at T =
1
r2 (t , T )
2(T t )
Discount Factor
If the semi-annually compounded rate is 5%,the
corresponding discount rate is:
1
0.05
1
2*1
= 0.95181
Semi-annual Compounding
We can also obtain the semi-annual compounding rate from the discount rate
r2 t , T 2
Z t,T
1
2 T t
For a one year discount rate of 0.95181, the semi-annually compounded interest
rate is
= 2*[{(1/(0.95181)0.5} 1]
= 0.05 or 5%
For FFF
by the equation
1
rn t , T n
Z t, T
1
n T t
rn t , T
n T t
Continuous Compounding
The continuously compounded interest
rate is obtained by increasing the
compounding frequency
to
r t ,T n
T
t infinity
Z t,T e
ln Z t , T
T t
Continuous Compounding
rn t , T
r t , T n ln 1
rn t , T n e
r t ,T
n
Z t , Ti 100 Z t , Tn
computed
2
i 1
Pc t , Tn
also:
n
c
Pz t , Ti Pz t , Tn
2 i 1
n
c / 2 100
100
Pc (t , Tn )
2(Ti t )
(1 r2 (t , Tn ) / 2) 2(Tn t )
i 1 (1 r2 (t , Ti ) / 2)
A No Arbitrage Argument
In well functioning markets in which both the coupon
bond Pc(t,Tn) and the zero coupon bond Pz(t,Tn) are
traded , if
c n
Pc t , Tn Pz t , Ti Pz t , Tn
2 i 1
then the arbitrageur can buy the bond for Pc(t,Tn)
and sell immediately c/2 units of zero coupon bond
with maturities T1,T2,,Tn-1 and (c/2+1) of the zero
coupon with maturity Tn
This strategy leads instantly to a profit. In a wellfunctioning market, such arbitrage opportunities
cannot last for long.
n
c 100
Z t , Ti 100 Z t , Tn
2
i 1
Example
On t = June 30, 2005, the 6-month Treasury bill,
expiring on T1 = December 29, 2005, was trading at
Rs.98.3607
On the same date, the 1-year to maturity, 2.75%
Treasury note, was trading at Rs.99.2343
The maturity of the latter Treasury note is T2 = June
30, 2006
We can write the value of the two securities as:
0.965542
Rs
.101.375
Rs
.101.375
Z(t,T1) = Rs.98.3607 / Rs.100 = 0.983607
.
Rs.101.5
= 0.947641
Bootstrap Methodology
With sufficient data we can obtain the discount factors for
every maturity This methodology is called bootstrap
methodology
Let t be a given date. Let there be n coupon bonds, with
coupon ci and maturities Ti. Assume that maturities are
regular intervals of six months. Then, the bootstrap
methodology to estimate discount factors, for every i = 1,
,n is as follows:
100 1 c1 / 2
100
P 100 1
d
360
and T
4.99%
182
bill issued at a price of100
Rs.97.477
for Rs.100 of face
value as:
100 P 365
P
n
rt ln
100
r
ln
t
100
c t 100 r2 t 0.5 s
100
1 r2 0.5 / 2
1 r2 0.5 / 2
s Z 0, t
t 0.5 +
Price with spread = Price of no spread bond
Value of bond at 0 =
PFR t , T Z t , Ti 1 100 1 r2 Ti / 2
Inverse Floater
An inverse floater is a security that pays a lower
coupon as interest rates go up.
A fixed reference rate is used from which the floating
rate is subtracted.
For example, if an inverse floater promises to pay
15% minus the short-term interest rate on an annual
basis with three years maturity, the coupon on the
bond is:
Inverse Floater
If it is assumed that the coupon is always positive,
the bond does not pay any coupon when the short
rate is more than 15%.
The coupon payments are a combination of a fixed
rate bond and a floating rate bond.
This is the same as having a long position in a fixed
rate bond and a short position in a floating rate
bond.
However, such a view would mean that at maturity,
the principal received from the fixed rate bond is
used to pay for the principal of the floating rate
bond
Inverse Floater
Thus, only a long position in a fixed rate bond and
a short position in a floating rate bond does not
mimic an inverse floater.
However, when a long position in a zero coupon
bond of the same maturity is added, the position
mimics an inverse floater.
Price of Inverse floater: PZ (0,3)+PC (0,3) PFR
(0,3)