# Tag Info

9

Your overall approach is correct. However to my knowledge it is formally more appealing to work with a parameterized and smoothed yield curve. Basically one assumes that the yield curve can be described by a smooth function $r(t,\alpha, \beta,\gamma)$ (mostly of three parameters) Given a set of market data $Y(t,T_1)\dots Y(t, T_n)$ one looks for ...

9

1. Observable instruments, spot rates, and forward rates First remember that something observable means that you can observe/find the rate in the market by looking at traded rate instruments or fixings. 1.1. Observed spot rates For simplicity, assume Zero Coupon Bonds (ZCBs) are traded with time left to maturity of 10Y, 15Y and 20Y. Hence, by observing ...

7

Chapter 1: Goldilocks is ousted by the bears Once upon a time, the banks used a fixing called LIBOR as a measure of the risk-free interest rate. Then the big hairy crisis came along and ate all our assumptions, leaving just the bones of the fixing (upon which everything else still fixes) and the mantle of risk-free rate proxy was passed on to a family of ...

7

Given a forward rate, for example: $F(t, T, T+\delta)$ The instantaneous forward rate $f(t,T)$ fixed in $t$ is the limit when $\delta \rightarrow 0$ of your forward rate. If the relation between forward rate and zero coupon bond is: $F(t,T,T+\delta) = \frac{p(t,T) - p(t,T+\delta)}{\delta p(t,T+\delta)}$ We have, f(t,T) = \lim_{\...

5

The CME' Fed Fund Futures are what you are looking for. http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html On settlement day they settle at the average overnight rate set by the Fed during the contract month.

5

Your equations are flawed. Also there is no expectation if the process $\{r_s\}$ is deterministic. The correct reasoning is, assuming $\{r_s\}$ is stochastic: $$f(t,u)=-\frac{d}{du}\ln P(t,u)=-\frac{\frac{d}{du}P(t,u)}{P(t,u)}\\ =-\frac{\frac{d}{du}E^Q_t[e^{-\int_t^u r_s ds}]}{P(t,u)} =\frac{E^Q_t[e^{-\int_t^u r_s ds} r_u]}{P(t,u)} =E^Q_t\left[\frac{e^{-\... 5 This is known as the classical Leibniz rule. The link sends to Wikipedia, where you can find a proof. It allows to differentiate under the integral sign. A general statement of the formula is:$$\text{d}\left(\int_{g(x)}^{h(x)}f(x,s)\text{d}s\right)=h'(x)f(x,h(x))\text{d}x-g'(x)f(x,g(x))\text{d}x+\int_{g(x)}^{h(x)}\text{d}f(x,s)\text{d}s$$4 The price of the zero-coupon bond is the discount factor for this maturity. In the world of exponential compounding formulas are of the form \exp(\sum \cdots). With a replication argument if we want to invest money for n years what can we do. We invest for one year r_0 = F(0,1) then after this year we invest for another year, the rate for this today is ... 4 The flaw is L(T,S) is a future spot rate that is determined at time T>t and unknown at present. It is correct that$$F(t,T,S)=\frac{1}{S-T}\left[\frac{P(t,T)}{P(t,S)}-1\right] \iff P(t,S)(S-T)F(t,T,S) = P(t,T) - P(t,S), $$as this is just the definition of the forward rate. However, you are saying that$$\frac1{P(t,T)}\frac1{P(T,S)}=\frac1{P(t,...

4

You may show it as follows: \begin{align*} f_{t,T}&= \left[ \frac{(1+r_T)^T}{(1+r_t)^t} \right]^{\frac{1}{T-t}}-1\\ &=e^{\frac{1}{T-t} \left[\ln (1+r_T)^T - \ln (1+r_t)^t \right]} -1\\ &\approx e^{\frac{1}{T-t} \left[(1+r_T)^T-1 - \big((1+r_t)^t -1\big)\right]} -1\\ &=e^{\frac{1}{T-t} \left[(1+r_T)^T - (1+r_t)^t\right]} -1\\ &\approx 1+ \...

4

Let $\{r_t\}_{t>0}$ be the spotrates and $f_{t,T}$ be the forward rate from time $t$ to $T$ for $t<T$. Then the general formula to compute $f_{t,T}$ is $$(1+r_T)^T=(1+r_t)^t(1+f_{t,T})^{T-t}$$ Now you can solve for $f_{t,T}$ to obtain: $f_{t,T}= \left( \frac{(1+r_T)^T}{(1+r_t)^t} \right) ^{1/(T-t)}-1$ In your example: Spot rates are given by the ...

4

For the instantaneous forward, please see the last page of this note: T-Forward Measure by Fabrice Douglas Rouah (http://www.frouah.com/finance%20notes/The%20T-Forward%20Measure.pdf). For the simple forward, you know the relationship between the price of the zero coupon and the simple forward: $\frac{P \left(t,T_{n}\right)}{P \left(t,T_{n+1}\right) }=1+\... 3 Consider a payer swaption with maturity$T_0$and strike$K$. Here the strike$K$is the fixed rate paid on the fixed leg of the underlying fixed-for-floating swap with reset dates$T_0, \ldots, T_{n-1}$and payment dates$T_1, \ldots, T_n$, where$0<T_0 < \cdots < T_n$. We assume that the swap exchanges the payments$L(T_{i-1}; T_{i-1}, T_i)\Delta ...

3

We consider the expectation \begin{align*} E^{Q_d^{t_f}} \Big(P_d(t_f, T) X_{t_f} \mid \mathcal{F}_t \Big), \end{align*} where $Q_d^{t_f}$ is the $t_f$-forward measure, and $P_d(t_f, T)$ is the price at $t_f$ of a domestic zero-coupon bond with maturity $T$. Note that $P_d(t_f, T) X_{t_f}$ is the value at time $t_f$ of the process \begin{align*} P_d(t,...

3

Which currency are you looking at ? Say that your 1y swap would have yearly fixed payments vs 3M floating payments. Your 1.5y swap would probably have: a fixed payment 6m after effective date and another fixed payment 18m after effective date regular quarterly floating payments Your curve was built with 1y and 2y swaps, nothing in the middle ? Then yes, ...

3

As a trader I used Black model (amongst others) to value swaptions, where the forward swap rate is the key observable underlying rate. Any market where the forward is the traded instrument would lend itself to Black.

3

it's easiest to see in terms of replication. The pay-off of a forward contract is $$S_T - K.$$ We can replicate this precisely and statically by buying one unit of stock, $S_0,$ and $Ke^{-rT}$ riskless bonds growing at rate $r.$ So its value today is $$S_0 - Ke^{-rT}.$$ This has zero value if and only if $K= S_0 e^{rT}.$ This value is then called ...

3

A very good and up-to-date question. Whether you use the LIBOR-rate or any other rate for discounting depends on what you decide to be the fundamental rates in the market. Before the crisis LIBOR-rates were mostly seen as the fundamental market rates (or the "risk-neutral" rates). After the crisis it turned out that these rates were not completely free of ...

3

You can start with $$P(t,T)=exp({-\int_t^T f_t(u).du})$$ then take derivative wrt to T $$R_F(0,T)=f_0(T)=-\frac{\partial} {\partial T}{ ln(P(0,T))}$$

3

For a swap, we have a sequence of re-setting and payment dates. The # of forward rates corresponding to the # of payment dates. For example, let us assume that we have $n$ payment dates $t_1, \ldots, t_n$, where $0< t_1 < \cdots < t_n$. Then there are $n$ forward rates. During the simulation, for time steps prior to $t_1$, there exist $n$ "...

3

We assume that, under the risk-neutral measure $Q$, \begin{align*} dP(t, T) = P(t, T)(r_t + \sigma(t, T)dW_t), \end{align*} where $\{W_t, \, t \ge 0\}$ is a standard Brownian motion. Then \begin{align*} dL(t) &= \frac{1}{T-S}\bigg(\frac{dP(t, S)}{P(t, T)} -\frac{dP(t, S)}{P^2(t, T)}dP(t, T) \\ &\qquad + \frac{dP(t, S)}{P^3(t, T)} \langle dP(t, T), \,...

3

You can only infer forward vol by pairing a mid-curve option with a spot option. It's easier to go through an example (I'll use 5y x 5y vol since I have the sketch below handy...) One decomposition of the 5y5y spot vol is as follows: 1y forward 4y x 5y vol: this is the implied vol of an option starting in 1 year, expiring 4 years thereafter, and eventually ...

3

Futures trading are settled on a daily basis meaning in the end of day, your account will be adjusted by your PnL. So of course your payment on T1 is not discounted. However forward is settled only once at expiration, hence you discount the whole duration.

3

In the simple case, you have as per first equation on your last slide: $\frac{P(t,T_0)}{P(t,T)}=1+\delta F(t,T_0, T)$ The continuous time equivalent, assuming constant piecewise rate, as per your question, is: $\frac{P(t,T_0)}{P(t,T)}=e^{y (T_0,T) \delta}$ Taking log of both sides, and rearranging: $\frac{1}{\delta} \ln {\frac{P(t,T_0)}{P(t,T)}}=y (T_0,... 3 The idea of assuming that the transaction cost is one half of the bid-offer spread comes from several assumptions: the positions are marked-to-market at mid; you can actually execute at bid or ask (that your trade isn't large enough to impact the market); there are no other fees or costs. For example: Bid-Ask Spreads: Measuring Trade Execution Costs in ... 3 Let us start from your last equation, and focus specifically on the expectation. Assuming that the end date of each period is the start period of the next, the idea is to simplify it using conditional expectations. Since$t < t_{n-2}$, we can write using the tower property of conditional expectations:$\begin{aligned} \Bbb{E}_{t}^{Q^{t_n}} \left[\prod_{... 3 I will try a simplified approach: LetP(t,T)$represent the price at time t of a zero coupon that pays 1 at time T. If you divide the period between t and T into n sub-intervals, assume$F \left( t; t_{i-1}, t_{i}\right)$represent the simple forward rate at time t for the interval between$i-1$and$i$, where we assume the length of each interval is equal ... 3 Assume the (annualised, continuously compounded) forward rate between two nodes, say$t_{10}$and$t_{12}$, is constant, say$ f_{10,12}$, then the discount factors of the two consecutive knots will be linked as follows:$D_{12}=D_{10}e^{-f_{10,12} \left(t_{12}-t_{10}\right)}=D_{10}e^{-2f_{10,12}}$From which is then easy to infer the formula for$t_{11}$, ... 2 The FRA A FRA is an agreement to exchange cash flows; the FRA in question is: Start 15/9/14 End 15/5/15 which is 242 days. USD Money Market quoting is Actual/360, so the accrual factor here is 242/360 = 0.6722. The FRA cashflows, therefore, are: on 15/9/14, Fix pays$\$1m * (0.6722 * 0.05) = \$33,611.11$, and Float pays$\$1m * (0.6722 * L)$, where L ...

2

There are two things that might be confusing you. The time step in Time dimensions and time steps along the forward curve. The first is given a time t from today until a certain day in the future, this dt usually is the next reset date. The the other is tau representing a tenor for the forward curve maturing in tau days ahead. Dtau could vary ...

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