Spot Rates, and Forward

Rates
Theoretical Spot Rates
The theoretical spot rate is the interest rate that should be used to
discount a default-free cash flow.

Because there are a limited number of on-the-run Treasury
securities traded in the market, interpolation is required to obtain the
yield for interim maturities; hence, the yield for most maturities used
to construct the Treasury yield curve are interpolated yields rather
than observed yields.

Default-free spot rates can be derived from the Treasury yield curve
by a method called bootstrapping.

The basic principle underlying the bootstrapping method is that the
value of a Treasury coupon security is equal to the value of the
package of zero-coupon Treasury securities that duplicates the
coupon bonds cash flows.
Theoretical Spot Rates
Bootstrapping
In order to value default-free cash flows, the
theoretical spot rate for Treasury securities must
be determined.

The default-free theoretical spot rate curve is
constructed from the observed Treasury yield
curve.

Several techniques are used to create the yield
curve; however, the most commonly employed
method is called bootstrapping
Bootstrapping Spot Rates
Bootstrapping uses the yield for the on-the-run
Treasury issues (since there are no credit or
liquidity risks).
A problem exists because there may be an insufficient
number of data points for on-the-run issues to construct
a yield curve.

Issuance of Treasury securities
3-month, 6-month, 2-year, 3-year, 5-year, and 10-year
notes (the 30-year has recently been reissued)
This leaves gaps in the yield curve which can be filled
in with simple linear interpolation
Bootstrapping Spot Rates
To fill in the gap for each missing one year maturity, it is
possible to start with the lowest maturity and work up to
the highest maturity with the following formula:

(yield at higher maturity yield at lower maturity)
Number of years between two observed maturity points

The estimated on-the-run yield for all intermediate whole-
year maturities is found by adding the amount computed
to the yield at the lower maturity.
Bootstrapping Spot Rates
Example: 2-year 4.52%, 5-year 4.66%, 10-year 4.80%, 30-year 5.03%

Using the above information, to bootstrap the 3- and 4-year Treasury rates,
the following interpolation of .0466% was computed as follows:
(4.66% 4.52%)
3 years

Then the interpolated 3-year rate would be:
4.52% + .0466% = 4.567%
The interpolated 4-year rate would be:
4.567% + .0466% = 4.614%

Therefore, when a yield curve is shown, many of the points are only
approximations. Exhibits 4 and 5 show an interpolated bootstrapped
Treasury yield curve.

This method produces only a crude approximation
Bootstrapping Spot Rates
Bootstrapping Spot Rates
Theoretical Spot Rates
The basic principle is that the value of a Treasury
coupon series should be equal to the value of a
package of zero-coupon Treasuries that
duplicates the coupon bonds cash flows.

Using the arbitrage-free method, it is possible to
compute the approximate yield of bonds (spot
rates) over any maturity range (including months)
and going forward in time.
These will be more precise that the linear interpolated
results from bootstrapping.
Exhibit 6 shows the plot of the theoretical spot rates
and the par value Treasury yield curve.
Theoretical Spot Rates
Method of Bootstrapping Spot
Rates from the Par Yield Curve
1. Begin with the 6-month spot rate.
2. Set the value of the 1-year bond equal to the
present value of the cash flows with the 1-year
spot rate divided by 2 as the only unknown.
3. Solve for the 1-year spot rate.
4. Use the 6-month and 1-yar spot rates and
equate the present value of the cash flows of
the 1.5 year bond equal to its price, with the
1.5 year spot rate as the only unknown.
5. Solve for the 1.5 year spot rate.
Example
Consider the yields on coupon Treasury bonds
trading at par (given in the table).
YTM for the bonds is expressed as a bond
equivalent yield (semi-annual YTM).
Par Yields for Three Semiannual-Pay Bonds
Maturity YTM Coupon Price
6 months 5.00% 5.00% $100.00
1 year 6.00% 6.00% $100.00
18 months 7.00% 7.00% $100.00
1. Begin with the 6-month spot rate.
The bond with six months left to maturity has a
semi-annual discount rate of 5%/2 = 2.5% or 5%
on a bond equivalent yield basis.
Since this bond will only make one payment of
$102.50 in six months, the YTM is the spot rate
for cash flows to be received six months from
now.
The bootstrapping process proceeds from this
point using the fact that the 6-month annualized
spot rate is 5%.
2. Set the value of the 1-year bond equal to the
present value of the cash flows with the 1-
year spot rate divided by 2 as the only
unknown. Solve for the 1-year spot rate.
The 1-year bond will make two payments, one in six
months of $3.0 and one in one year of $103.0,
and that the appropriate spot rate to discount the
coupon payment (which comes 6 months from
now), is written as:
$3.0/(1.025)
1
+ $103.0/(1+z
2
/2)
2
= $100
where z
2
is the annualized 1-year spot rate
3. Solve for the 1-year spot rate.
$3.0/(1.025)
1
+ $103.0/(1+z
2
/2)
2
= $100
where z
2
is the annualized 1-year spot rate.

Solve for z
2
/2 as: $103.0/(1+z
2
/2)
2
= $100 - $3/1.025
= $100 - $2.927 = $97.073
or:
$103.0/$97.073 = (1+z
2
/2)
2

So: sq. root of ($103.0/$97.073) -1 = z
2
/2 = 3.0076%

1-yr Spot rate (z
2
) = 3.0076% times 2 = 6.0152%

4. Use the 6-month and 1-year spot rates and
equate the present value of the cash flows
of the 1.5 year bond equal to its price, with
the 1.5 year spot rate as the unknown.
Now that we have the 6-month and 1-year spot rates,
this information can be used to price the 18-month bond.
Set the bond price equal to the value of the bonds cash
flows as:
$3.5/(1.025)
1
+ $3.5/(1.030076)
2
+
$103.5/(1+z
3
/2)
3
= $100
where z
3
is the annualized 1.5-year spot rate.

5. Solve for the 1.5 year spot rate.
$3.0/(1.025)
1
+ $3.5/(1.030076)
2
+ $103.5/(1+z
3
/2)
3
= $100
where z
3
is the annualized 1.5-year spot rate.

Solve for z
3
/2 as: $103.5/(1+z
3
/2)
2
= $100 - $3.5/1.025 -
$3.5/(1.030076)
2
= $100 - $3.415 - $3.30 =$93.285
or:
$103.5/$93.285 = (1+z
3
/2)
2

So: cube root of ($103.5/$93.285) -1 = z
3
/2 = 3.5244%

1.5-yr Spot rate (z
3
) = 3.5244% times 2 = 7.0488%

Bootstrapping Exercise
A top manager in a multinational bank asks his research
group to find out trade opportunities existing in the bond
market. The research group first looked at the bond market
and found the following tradable bonds

Maturity NO of HY Coupon YTM Price Spot Rate
0.5 1 0 0.08 96.15 0.08
1 2 0 0.083 92.19 0.083
1.5 3 0.085 0.089 99.45
2 4 0.09 0.092 99.64
2.5 5 0.11 0.094 103.49
3 6 0.095 0.097 99.49
3.5 7 0.1 0.1 100
4 8 0.1 0.104 98.72
4.5 9 0.115 0.106 103.16
5 10 0.0875 0.108 92.24
5.5 11 0.105 0.109 98.38
6 12 0.11 0.112 99.14
6.5 13 0.085 0.114 86.94
7 14 0.0825 0.116 84.24
7.5 15 0.11 0.118 96.09
8 16 0.065 0.119 72.62
8.5 17 0.0875 0.12 82.97
9 18 0.13 0.122 104.3
9.5 19 0.115 0.124 95.06
10 20 0.125 0.125 100
Bootstrapping Exercise
They also decided to look at the Zero coupon yields as per
fundamentals for different maturities using their own
econometric model.






They then decided to find out the market predicted rates
through bootstrapping. What are the trading opportunities?


Maturity Yr Model
1 0.085
2 0.089
3 0.098
4 0.107
5 0.109
6 0.11
7 0.114
8 0.118
9 0.133
Forward Rates
Besides default-free theoretical spot rate curves
extrapolated from the Treasury yield curve, it is
possible to compute forward rates.

Since forward rates are extrapolated from the
default-free theoretical spot rate curve, these
rates are referred to as implied forward rates.

Besides using the Treasury yield curve, it is
possible to compute forward rates from other
interest rate curves (i.e. LIBOR).
Forward Rates
Using arbitrage arguments, forward rates
can be extrapolated from the Treasury
yield curve or the Treasury spot rate curve.

The spot rate for a given period is related
to the forward rates; specifically, the spot
rate is a geometric average of the current
6-month spot rate and the subsequent 6-
month forward rates.
Forward Rates
Notation:
1
f
1


Definition of forward rate: The implied
rate of return on a security to be issued
at some future date.

Definition of spot rate: The rate of return
on securities already issued.
when issued time to maturity
Spot and Forward Rates for Fixed
Income Securities
A spot rate is a rate agreed upon today, for a
loan that is to be made today. (e.g. r
1
= 5%
indicates that the current rate for a one-year
loan is 5%).

A forward rate is a rate agreed upon today, for a
loan that is to be made in the future. (e.g.
2
f
1
=
7% indicates that we could contract today to
borrow money at 7% for one year, starting two
years from today).
Forward Rates
Forward rates of interest are implicit in the term structure of interest rates

t = 0 1 2 3 4







Note the notation:
3
f
4
means the forward rate from period 3 to period 4.

When the beginning subscript is omitted, it is understood that the forward
rate is for one period only:
3
f
4
= f
4
.
r
1
r
2
r
3
1
f
2
2
f
3
3
f
4
General Formula for Forward Rates
One-period forward rates:




n-period forward rates:


(1 + r
n
)
n
(1+ r
n1
)
n1
(1 + f
n
)
1
imply ing that ...
f
n
=
(1 + r
n
)
n
(1+ r
n1
)
n1
1
(1 + r
k +n
)
k+ n
(1 + r
k
)
k
(1 +
k
f
k+ n
)
n
imply ing that...
k
f
k+ n
=
(1 + r
k+ n
)
k+ n
(1 + r
k
)
k




(

(
(
1
n
1
Example: Forward Rates
What one-year forward rates are implied by the
following spot rates?







Maturity Year Spot Rate (r
t
) Forward Rate (f
t
)
1 4.0%
2 5.0% 6.01%
3 5.5% 6.507%
(1 + r
2
)
2
= (1+ r
1
)(1+ f
2
)
(1.05)
2
= (1.04)(1 + f
2
)
f
2
= 6.01%
(1 + r
3
)
3
= (1 + r
2
)
2
(1 + f
3
)
(1.055)
3
= (1.05)
2
(1 + f
3
)
f
3
= 6.507%
Implied Forward Rate Example
Suppose the spot term structure of zero-
coupon yields is: {r
1
=0.08,

r
2
=0.10,

r
3
=0.13,

r
4
=0.14,}

If investors wish to invest $1,000,000 for two
years. They can choose between:
buying a 2-yr. discount bond, and
buying a sequence of two 1-yr. bonds, i.e.,
one now and one in one year from now.
What Will the Investor Choose?
The alternative that pays the higher
cumulative return over the 2-yr time horizon.

Caveat: The rate of return on the bond
issued one year from now is uncertain.

How do we estimate it?
With the implied forward rate
Estimating the Implied Forward Rate




Underlying assumption: These must be
equal cumulative returns, with no arbitrage
possible.

2
1 1 1 2
2 2
2
1 1
1
(1+ f )(1+r ) =(1+r )
(1+r ) (1.1)
(1+ f ) = = =1.12 12%
(1+r ) (1.08)
Estimation of Implied Forward Rates
(using the spot term structure from a previous slide)

t= 0 1 2 3 4
3
f
1
1
f
2
2
f
2
1
f
3

3 1
3 4
3 1 3 4
4
4
3 1
3
3
(i) f is given by:
(1+ f )(1+r ) =(1+r )
(1+r )
(1+ f )= =1.17 or 17%
(1+r )
Estimation of Implied Forward
Rates (continued)

1 2
2 3
1 2 1 3
3 3
3
1 2
1
1 3
3 4
1 3 1 4
4 4
1 1
4
3 3
1 3
1
(ii) f is defined by:
(1+ f ) (1+r ) =(1+r )
(1+r ) (1.13)
(1 + f ) = = =1.1558 or 15.58%
(1+r ) (1.08)
(iii) f is defined by:
(1+ f ) (1+r ) =(1+r )
(1+r ) (1.14)
(1+ f ) =( ) =( ) =1.1605 or 16.05%
(1+r ) (1.08)
General Formula for Implied
Forward Rates



Note that implied fwd rates are internally
consistent, e.g.,
(
(

1
i+j j
i+j
i j
i
i
(1+r )
1+ f =
(1+r )
2 3
1 2 3 1 1 3
1
2 3
1 3 1 2 3 1
(1 ) (1 ) (1 )
(1 ) (1 ) (1 )
f f f
f f f
+ + = +
+ = + + (

Deriving a 6-Month Forward Rate
To compute a 6-month forward rate, it is necessary to utilize
a yield curve and the corresponding spot rate curve.

The following 2 investments should have the same
value:
1-year Treasury bill and
2 six-month Treasury bills (one purchased now and the other in
six months)

An investor should be indifferent since they should
produce the same investment income over the same
investment horizon.
Deriving a 6-Month Forward Rate
Although an investor does not know the interest rate of the
second 6-month T-bill, it is possible to compute it because
the forward rate must such that it equalizes the dollar
return between the two alternatives.

Exhibit 11 shows the timeline for the two investment
alternatives:
The value of first six-month T-bill is: X(1 + z
1
)
The value of the total investment following the second six-
month T-bill is: X(1 + z
1
)(1 + f)
Where z
1
is one-half the bond-equivalent yield of the 6-month spot
rate and f is one-half the forward rate on a 6-month Treasury bill
available 6 months from now. X is the amount of the investment.
Deriving a 6-Month Forward Rate
Relationship Between Spot Rates and Short-
Term Forward Rates
The value of alternative investment (a 1-year T-bill) is computed as:
X(1 + z
2
)
2


Because the two alternatives should generate identical returns:

X(1 + z
1
)(1 + f) = X(1 + z
2
)
2


Solving for f = [(1 + z
2
)
2
/ (1 + z
1
)] -1

Multiplying f by 2 to get the forward rate on a bond-equivalent yield
basis.

Forward rates can be computed on various combinations of short-
and longer-term interest rates

Example
Alternative 1. Buy a 5 year (10 p)
ZC T-Bill
Alternative 2. Buy a 3- year (6 p) ZC
T Bill and when it matures buy a 2
year ZC T-Bill
Given:
3 yr spot= 0 .09787
5 Yr spot= 0.11021