CASMA 577 LECTURE 2: EXTRA NOTES ON ZERO RATES

• zero rate (zero-coupon interest rate) If one invests x dollars now and gets y dollar in n
years without any intermediate payment, then
y = xer·n (1)
with r being the so-called zero-coupon interest rate.1 You can take (1) as the definition of the
zero-coupon interest rate (zero rate for short). Solving (1) leads to2
r= 1
n log( xy ) (2)
Example 1. If a five-year zero rate with continuous compounding is quoted as 5%
per annum, then $100 invested for 5 years grows to be
$100 × e0.05×5 = $128.402541669... ≈ $128.40.
Meanwhile, the present value (today = Sept. 19, 2024) of
$100 on Sept. 19, 2029
is equal to
$100 × e−0.05×5 = $77.8800783071... ≈ $77.88.
Remark. When we compare two future values, say, at times t1 and times t2 (in the unit of
years), we need to put them at the same time in order to compare.
Example 2. Suppose r denotes the annual interest rate and we use the continuous
compounding. Then, X dollars at the future time t1 (i.e., t1 years from now) and Y
dollars at the future time t2 (i.e., t2 years from now) have present values:
Xe−rt1 and Y e−rt2 .
With r = 5%, X = 110, Y = 115, t1 = 1, t2 = 2, we have (via a calculator)
110e−0.05 > 115e−0.1 .
That is, 110 USD in a year is more valuable than 115 USD in two years.

• Bonds with periodic coupon payments. Let us first briefly introduce the term “bond”.
Bonds are issued by governments and corporations when they want to raise money. By
buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face
value of the loan on a specific date, and to pay you periodic interest payments (known
as coupons) along the way, for example,
(A) annually (once per year)
(SA) seminnually (twice per year)
(Q) quarterly (four times per year)
Next, we will illustrate via an example how to determine the bond price by using given zero
rates.
1As we will see shortly, it is like you are buying a bond without any coupon payment.
2I use log x to denote the logarithm function with base e. That is, y = log x if and only if x = ey .
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The 5% zero rate corresponding to the 0.5 year maturity means that if you invest 100 USD for a
half year on a zero-coupon and only receive the face value Y at the end of this half year period,
the equivalent annual interest rate is 5%: That is,
Y = 100e0.05×0.5 .

Example 3. Using the zero rates in the above Table 4.2, determine the price of a
two-year bond with
– face value = $100
– coupon rate = 6% per annum paid semiannually (SA).
Explanation. Annual coupon rate is 6%. This means that 6% of the face value $100
(which is $6) will be paid to the bond holder. In this problem, the coupon is paid
semiannually meaning that the bond holder will receive $3 every six months:
• When you purchase this bond, you pay its price, which is what we want to determine.
(i) At the end of the sixth month, you get $3 as the first coupon payment.
(ii) At the end of the first year, you get $3 as the second coupon payment.
(iii) At the end of the 18th month, you get $3 as the third coupon payment.
(iv) At the end of the second year, you get $3 as the fourth coupon payment and get
the face value $100 (so in total $103).
The values in (i)-(iv) are at different future times and we need to translate them into a
common time to be compared. We will take the present time as this reference, mainly
because we need to know its present value so as to use it as the right price to purchase
the bond. The corresponding present values of the money in (i)-(iv) are computed using
the given zero rates
$3e−0.05×0.5 , $3e−0.058×1 , $3e−0.064×1.5 , and $103e−0.068×2 .
Adding these four numbers together leads to the price of the bond:
$3e−0.05×0.5 + $3e−0.058×1 + $3e−0.064×1.5 + $103e−0.068×2
= $98.3850627729.... (3)
≈ $98.39.
So the right bond price is $98.39. End of Explanation.
Following the above Example 3, one can see that spending $98.39 now, you will get 4 coupon
payments ($3 for each) and one final payment of the face value $100. So what is the annual
yield (denoted by y) of this bond?
Answer. Let y denote the annual yield, we have the following equation

3e−y×0.5 + 3e−y×1 + 3e−y×1.5 + 103e−y×2 = 98.39.

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(Compare this one with (3)) Then, one can solve this equation numerically (e.g., via Newton-
Raphson’s method) to get y ≈ 6.76%.

• Par yield. We know that the face value (also called the par value, principal) is the amount
of money you will get from the bond issuer at the end of the bond contract, besides any coupon
payments you get. As we see from the previous example, the price at which you buy the bond
may be different from the face value. By adjusting the coupon rate, it is possible to
make the price and face value equal. This particular coupon rate is called par yield.
Following the above Example 3 and using the zero rates in the above Table 4.2, with
c denoting the par yield, we have
−0.05×0.5 100c −0.058×1 100c −0.064×1.5

−0.068×2
100 = 100c
2 e + 2 e + 2 e + 100c
2 + 100 e ,

where 100c
2 is the coupon payment one gets every 6 months. Solving the above equation,
we get
c = 6.87%.

Previously, we used the given zero rates to compute the price of a bond. Next, we will
determine the zero rates based on a collection of data on several bonds.

• Determine the zero rates (? ? ? bootstrap method ? ? ?).

Let us illustrate the bootstrap method in the following example. There are five bonds with
the following data.
Bond principal ($) Time to maturities (years) Annual coupon ($) Bond price ($)
(1) 100 0.25 0 (Q) 99.6
(2) 100 0.5 0 (SA) 99
(3) 100 1 0 (A) 97.8
(4) 100 1.5 4 (SA) 102.5
(5) 100 2 5 (SA) 105
(Table 4.3 in Hull’s book; see page 1 of this PDF for (Q), (SA), and (A))
Note that there is no coupon payment for the first three bonds. We can then get the zero rates
with the corresponding maturities. We will write Rt to denote the zero-rate with maturity t
(per annum).
(1) From 99.6eR0.25 ×0.25 = 100, we get

R0.25 = 1.603%

(2) From 99eR0.5 ×0.5 = 100, we get

R0.5 = 2.01%

(3) From 97.8eR1 ×1 = 100, we get

R1 = 2.225%
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(4) Note that for the fourth bond, there are two coupons per year (so in total three coupon
payments in the 1.5-year period). The cash flow for this bond holder is
now : − 102.5
0.5 year : +2 → present value = 2e−R0.5 ×0.5
1 year : +2 → present value = 2e−R1 ×1
1.5 years : + 102 → present value = 102e−R1.5 ×1.5 ,
which leads to the following equality (no arbitrage):
102.5 = 2e−R0.5 ×0.5 + 2e−R1 ×1 + 102e−R1.5 ×1.5 .
Using what we have obtained in last steps (i.e., R0.5 = 2.01% and R1 = 2.225%), we can
get
R1.5 = 2.284%.
(5) Note that for the last bond, there are two coupons per year (so in total four coupon
payments in the 2-year period). The cash flow for this bond holder is
now : − 105
0.5 year : + 2.5 → present value = 2.5e−R0.5 ×0.5
1 year : + 2.5 → present value = 2.5e−R1 ×1
1.5 years : + 2.5 → present value = 2.5e−R1.5 ×1.5
2 years : + 102.5 → present value = 102.5e−R2 ×2 ,
which leads to the following equality (no arbitrage):
105 = 2.5e−R0.5 ×0.5 + 2.5e−R1 ×1 + 2.5e−R1.5 ×1.5 + 102.5e−R2 ×2
Using what we have obtained in last steps (i.e., R0.5 = 2.01%, R1 = 2.225% and R1.5 =
2.284%), we can get
R2 = 2.416%.
As the maturity varies, the corresponding zero rate varies. In other words, the zero-rate
Rt with maturity t (per annum) is a function of time. Its graph is called the zero curve.
In practice, there are finitely many points (known zero rates at several time instants), people
commonly assume that the zero curve is linear between points determined by the above bootstrap
method. For example,
1 2.01% + 2.225%
R0.75 = (R0.5 + R1 ) = = 2.1175%.
2 2