Lesson 5 of 7 · All lessons in this module
- Forward price versus forward value: inception and expiration
- Valuing a forward during its lifeVideo lesson
- Forwards on assets with costs and benefits
- Pricing and valuing FX forwardsVideo lesson
- Term structure: zero rates and discount factors
- Implied forward ratesVideo lesson
- Forward rate agreements (FRAs)Video lesson
Lesson 5 of 7 · 13 min
Term structure: zero rates and discount factors
Interest rates differ by maturity, so interest rate derivatives are built from zero rates bootstrapped out of coupon bond prices, and their price equivalents, discount factors.
In short
- Interest rates have a term structure: a different rate for each maturity. The same applies to credit spreads, implied volatility and, with two curves, FX.
- A zero rate (spot rate) is the yield on a single cash flow at time i. A one-period bond's YTM equals .
- Bootstrapping solves for zero rates one maturity at a time, using the zero rates already found to discount earlier coupons.
- Discount factor: , the price today of one unit of currency at time i.
- An asset with a known future value must trade at its PV; if it does not, borrow-and-buy (or sell-and-lend) earns a riskless profit.
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