Lect8 Chp24-25

Financial Market Risks
Lesson 8
Government bonds
and
Interest rates
Prof. Dr. Didier Sornette 1 D-MTEC Chair of Entrepreneurial Risks

2
Topics Covered
“FIXED INCOME”
ØValue of a bond and YTM (Yield-to-Maturity)

ØReal and Nominal Rates of Interest
ØThe Term Structure
ØHow Interest Rate Changes Affect Bond Prices
Ø Modelling the Term Structure
Ø Causal dependences between interest rates,
stock markets and the real economy
Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

3
Web Resources
Book: Brealey / Myers / Allen, Corporate Finance (7th ed.)
CHAPTERS 3, 24 and 25
Additional reading (https://xyotta.com)
•O. Vasicek, An equilibrium characterization of the term structure, Journal of Financial Economics
5, 177-188 (1977)
•F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, Throwing away a billion dollars: the cost of
suboptimal exercise strategies in the swaptions market Journal of Financial Economics 62, 39-66
(2001).
•P. Santa-Clara and D. Sornette, The Dynamics of the Forward Interest Rate Curve with Stochastic
String Shocks, The Review of Financial Studies 14(1), 149-185 (2001)
www.fintools.com
www.loanpricing.com
www.smartmoney.com Web Links
https://stockcharts.com/freecharts/yieldcurve.php
www.pimco.com
4
What is a bond?
A bond is a securitized loan
Ø Principal amount: 
the amount over which the issuer pays
interest, and which has to be repaid at
the end.
Ø Coupons
– Coupon rate 
the interest rate the issuer pays to
the bond holder
– Coupon dates 
the dates on which the coupons
are paid
Ø Maturity: 
the date on which, the issuer has to
repay the principal amount.

5
Ancestor example
Source: http://www.tschoepe.de/auktion51/auktion51.htm
A bond from the Dutch East India Company (Vereenigde Oostindische Compagnie), dating from 7 November 1623, for
the amount of 2,400 florins; written out and authorized in Middelburg, but signed in Amsterdam.

6
BANK IN ZÜRICH
http://www.tschoepe.de/auktion51/auktion51.htm
7
Valuing a Bond
ØThe simplest kind of bond is the Zero-

coupon bond (or discount bond):
– B(t,s): price, at time t, of a bond maturing at time
s≥t, with maturity value $1 
It is the Present Value (at t) of 1$ received at s.

8
Valuing a Bond
ØZero-coupon bond (discount bond):
– B(t,s): price, at time t, of a bond maturing at time
s=t+T≥t, with maturity value $1 
It is the Present Value (at t) of 1$ received at s=t+T.
ØIts internal rate of return is the
Yield-to-Maturity:

9
Terminology
Ø Zero-coupon bond (discount bond):
– B(t,s): price, at time t, of a bond maturing at time s≥t,
with maturity value $1 
It is the Present Value (at t) of 1$ received at s.
Ø Yield-to-Maturity (Internal rate of return):
Ø The spot rate:
r (t ) = lim+ R(t , T ) = −∂ s ln B (t , s ) s =t
T →0

10
Valuing a Bond
Ø A bond pays a coupon Ci at each time ti from
now, i=1,…N and redeems the principal P at
time tN. What is the price of the bond?
ØValue of a bond = Present value of its future

cash-flows
Yield-to-maturity (Internal Rate of Return)

11
Equivalence between continuous and discrete time discounting
N periods with rate R per period and r per unit time covering
a total time interval T
1 1 ⎛ ⎛ T ⎞⎞ ⎛ T⎞
= = exp⎜−n ln⎜1+ r ⎟⎟ ≈ exp⎜ −rn ⎟ = exp(−rt n )
(1+ R) ⎛⎜1+ r T ⎞⎟ ⎝ ⎝ N ⎠⎠ ⎝ N⎠
n n
⎝ N⎠

12
Impact of interest rates on bond price

Ø To induce people to save, r⇑ to increase future (1+r)n
value
Ø If r⇑, present value of future fixed payments⇓
Value of bond⇓
1
1/(1+y)n
Percent
15.00
11.25
0.00
3.75
7.50
Jan-85
Oct-85
Jul-86
Apr-87
Prof. Dr. Didier Sornette

Jan-88
Oct-88
Jul-89
Apr-90
short-term bond
Jan-91
Oct-91
Jul-92
www.er.ethz.ch
Apr-93
Jan-94
Oct-94
Jul-95
Apr-96
Jan-97
long-term bond
Oct-97
UK Bond Yields
Jul-98
Apr-99
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
D-MTEC Chair of Entrepreneurial Risks
Oct-03
13
14
US Bond Yields
2007 2008

15
Debt & Interest Rates

Classical Theory of Interest Rates (Economics)
Ø developed by Irving Fisher
Nominal Interest Rate = The rate you actually pay when

you borrow money
Real Interest Rate = The theoretical rate you pay when you
borrow money, as determined by supply and demand
r
Supply = view point of the lender
Real r
Demand = view point of the borrower
$ Qty

16
Debt & Interest Rates

Nominal r = Real r + expected inflation
Real r is theoretically somewhat stable
Inflation is a large variable
Q: Why do we care?
A: This theory allows us to understand the Term Structure of
Interest Rates.
Q: So What?
A: The Term Structure tells us the cost of debt.

17
Term Structure and Yields

The Return on US Treasury Bills and the Inflation rate (1953-2003)
15.000
Treasury Bills
Inflation
10.313
Percent
5.625
0.938
-3.750
1953
1956
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
18
Consumer Price Index
three S-curve surges 1970-80
WWII
WWI
(Thomas J. Sargent)
Source: sharelynx.com
Prof. Dr. Didier Sornette D-MTEC Chair of Entrepreneurial Risks
Nominal exchange rates against the US dollar (rebased to 1900 =1)
Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (2002) |
US$-CHF 1913-2015
-4.0% per year
http://www.measuringworth.com/ | 23
Use EMH to make new predictions
(Fama, 1975)
§ Expected returns on bills predict inflation
§ expected inflation predicts bill rates
Fama lecture on the history of the Efficient Market Hypothesis
D. Sornette – ETH Zurich – http://www.er.ethz.ch/

Bond Bubble, Or Rational Expectations? Visualizing 220 Years Of Treasury Yields
Near multi-generational low bond yields, driven at least in part (and some think in full) by the undeniably large asset purchase program (Quantitative Easing
(QE)) that the US Federal Reserve has been implementing in one form or another since the 2008 Global Financial Crisis (GFC), have pushed the question of
whether or not the bond market is a bubble to the front of many people's minds. However, while the chart below of over 220 years of 10-year treasury yields
shows the extraordinarily low bonds yields, they have resulted from many fundamental and rational drivers (expectations of weak economic growth and safe
haven flows amid the European sovereign debt crisis) in addition to Fed purchases. So while bond prices look expensive, there is nothing particularly bubbly
about theProf.
bondDr. Didier
market Sornette
today. D-MTEC Chair of Entrepreneurial Risks
http://www.zerohedge.com/news/2013-04-23/bond-bubble-or-rational-expectations-visualizing-220-years-treasury-yields
trend of Long-Term Yields (%)

Federal funds target rates
Oct. 2019
https://fred.stlouisfed.org/series/FEDFUNDS
28
29
Federal funds target rates
Oct. 2019

30
Federal Funds Rate compared to U.S. Treasury interest rates
Oct. 2019

31
Spread between US Treasuries and German bunds
4 Aug. 2017
When no one can price risk anymore, when there’s in fact no apparent difference anymore between euro junk
bonds and US Treasuries, then all kinds of bad economic decisions are going to be made and capital is going to
get misallocated
34
US$ 30-year US Treasury bond price
Ø If r⇑, present value of future fixed payments⇓ 1
1/(1+y)n
36
Valuing a Bond
Ø A bond pays a coupon Ci at each time ti from
now, i=1,…N and redeems the principal P at
time tN. What is the price of the bond?
ØValue of a bond = Present value of its future

cash-flows
Yield-to-maturity (Internal Rate of Return)

37
Valuing a Bond
Example 1:
Ø If today is October 2005, what is the value of the following
bond? An IBM Bond pays $115 every Sept for 5 years. In
Sept 2010 it pays an additional $1000 and retires the bond.
The bond is rated AAA (WSJ AAA YTM is 7.5%)
(Wall Street Journal AAA Year-to-Maturity=7.5%)
Cash Flows
Sept 06 07 08 09 10
115 115 115 115 1115
with YTM = 7.5%)

38
Valuing a Bond
Example 1:
Ø If today is October 2005, what is the value of the following
bond? An IBM Bond pays $115 every Sept for 5 years. In
Sept 2010 it pays an additional $1000 and retires the bond.
The bond is rated AAA (WSJ AAA YTM is 7.5%)

39
Valuing a Bond
ØIn the previous example the YTM was
given. But, in practice, how do you evaluate
the YTM of a bond?
Ø A bond can be seen as a portfolio of zero-

coupon bonds

40
Valuing a Bond
! Payoff of the bond:
t1 t2 tN-1 tN
↓ ↓ ↓ ↓
C1 C2 … CN-1 CN+P
! Replication:
– Invest $ C1xB(t,t1) at t " Receive $C1 at t1
– Invest $ C2xB(t,t2) at t " Receive $C2 at t2
– Invest $ CN-1xB(t,tN-1) at t " Receive $CN-1 at tN-1

– Invest $ (P+CN)xB(t,tN) at t " Receive $(P+CN) at tN
Present value of the Payoff of the bond

replication portfolio
41
Valuing a Bond
ØIn the absence of arbitrage opportunity, the value of the
bond is equal to the value of its replication portfolio:
In the absence of arbitrage opportunity, the knowledge of the price

of all the zero-coupon bonds allows pricing any bond
ØTerm-structure: the sequence of bonds, yields, interest

rates at different times-to-maturity
42
Yield To Maturity
Example 2:
ØA $1000 treasury bond expires in 5 years.
It pays a coupon rate of 10.5%. If the
market price of this bond is $1078.80, what
is the YTM?

43
Yield To Maturity
Example 2:
ØA $1000 treasury bond expires in 5 years. It pays
a coupon rate of 10.5%. If the market price of this
bond is $1078.80, what is the YTM?
PV C1 C2 C3 C4 C5
1078.80 105 105 105 105 1105
x=0.92 => R=1/x-1 : Calculate R = 8.5%

44
Yield curve (Feb 2004)

Yield curve: Yield-to-Maturity vs. Maturity
5.00
3.95
Percent
2.90
1.85
Nov 2014
Feb 2004
0.80
Maturity Year
45
Term Structure
YTM (r)
Inverted
Normal
Flat or Humped
1 5 10 20 30 Year
Ø Normal yield curve: positive slope
– Investors expect the economy to grow in the future in association with a risk of rising
inflation,
– This expectation generates both
• an expectation that the central bank will rise short term interest rates in the future to slow
economic growth and dampen inflationary pressure
• and the need for a risk premium associated with the uncertainty about the future rate of
inflation and the risk this poses to the future value of cash flows.
– Investors price these risks into the yield curve by demanding higher yields for
maturities further into the future.

46
Term Structure
YTM (r)
Inverted
Normal
Flat or Humped
Year
1 5 10 20 30
Ø Normal yield curve: (economic growth, rising inflation, uncertainty)
Ø Inverted yield curve:
ü long-term investors think the economy will slow or even decline in the
future and then will settle for lower yields.
• indicate a worsening economic situation in the future
• investors believe inflation will remain low.
ü technical factors such as a flight-to-quality or global economic situations
may cause demand for bonds on the long end of the yield curve causing rates
to fall (e.g. LTCM 1998)

47
Term Structure
YTM (r)
Inverted
Normal
Flat or Humped
Year
1 5 10 20 30
Ø Normal yield curve: (economic growth, rising inflation)
Ø Inverted yield curve: (economic decline, low inflation, flight to quality)
Ø Flat of humped yield curve:
– Large uncertainty about the future economic situation
– Can either revert to a normal yield curve or result into an inverted yield curve

48
Yield curve dynamics
http://www.stockcharts.com/charts/yieldcurve.html
49
Yield curve dynamics
The 2015–16 stock market selloff was the period of decline in the value of stock prices globally that occurred
between June 2015 to June 2016. It included the 2015–16 Chinese stock market turbulence, in which the SSE
Composite Index fell 43% in just over 2 months between June 2015 and August 2015, which culminated in
the devaluation of the yuan. Investors sold shares globally as a result of slowing growth in the GDP of China,
a fall in petroleum prices, the Greek debt default in June 2015, the effects of the end of quantitative easing in
the United States in October 2014, a sharp rise in bond yields in early 2016, and finally, in June 2016,
the United Kingdom European Union membership referendum, 2016, in which Brexit was voted upon.
https://en.wikipedia.org/wiki/2015%E2%80%9316_stock_market_selloff
https://stockcharts.com/freecharts/yieldcurve.php

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
1980 1990 2000 2010 2019
30 Nov. 2019
yield curves are not the forecasters they are made out to be
Oct. 25. 2019
54
Sensitivity & Duration

1500
1300
Price
1100
900
700
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
5 Year 9% Bond 1 Year 9% Bond
Line 3
Yield
55

ØQuestion: how does the price of a bond
evolve when the YTM changes?
– Consider a bond that pays a coupon C each
year, for the next N years and redeems the
principal P at the end of year N with the last  
coupon. The YTM is R. 
The value of the bond is:

56

The value of a bond is:
Bond Price, percent
V(R)
R
YTM

57

ØQuestion: how does the price of a bond
evolve when the YTM changes?
– The YTM is now R+dR. The new value of the
bond is:
V’(R)

58

ØSensitivity of a zero-coupon bond that pays
$1 and T years
Duration of the
zero-coupon bond

59
Duration Calculation
y: yield to maturity
1 ⎛ 1.d 2.d n.( F + d) ⎞
Duration: D = ⎜⎜ + + ...+ n ⎟
⎟
V ⎝1+ y (1+ y) 2
(1+ y) ⎠
Bond value:
Sensibility is proportional to Duration

60
Ø For any bond, the quantity can

be interpreted as the duration of the bond.
ØBy definition: 
 
 
 
 
The duration of a bond is the average of coupon dates weight by the
present value of the coupons relative to the total value of the bond
Ø By construction:
61
Duration
Example (Bond 1)
Calculate the duration of a 5 years, 6 7/8 % bond @ 4.9 %
YTM
Year CF PV@YTM % of Total PV% x Year

1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 1068.75 841.39 .775 3.875
1085.74 1.00 Duration 4.424
62
Duration
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is
this bond’s duration?
Year CF PV@YTM % of Total PV% x Year

1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 Duration= 4.249

Spot/Forward rates
Imagine that Julie wants to invest $1 for two years.
Prof. Dr. Didier Sornette 63 D-MTEC Chair of Entrepreneurial Risks

64
Spot/Forward rates
(1+r2)2 = (1+r1) (1+f2) but not exactly equal to (1+r1) (1+r21))

to take into account risks
65
Spot/Forward rates
Coupons paying bonds to derive rates
C1 C2
Bond Value = +
(1+R) (1+R)2
C1 C2
Bond Value = +
(1+f1) (1+f1)(1+f2)
d1 = C1 d2 = C2
(1+f1) (1+f1)(1+f2)

66
FORWARD RATES
The Term Structure can be reflected in using various “r” terms
for different time periods
Example:
1000 1000
=
(1+r3)3 (1+f1)(1+f2)(1+f3)
yield to maturity forward rates
Forward Rate Computation
(1+ rn)n = (1+ r1)(1+f2)(1+f3)....(1+fn), n=1,2,…

with f1=r1
67
Spot/Forward rates
Example 1:
What is the 3rd year forward rate?
2 year zero treasury YTM = 8.995

68
Spot/Forward rates
Example 1:
What is the 3rd year forward rate?
Answer: (1+ r3)3 = (1+ r2)2 (1+f3)
Final Value of principal @ YTM

2 yr 1000 x (1+ r2)2 = 1000 x (1.08995)2 = 1187.99
3 yr 1000 x (1+ r3)3 =1000 x (1.09660)3 = 1318.70
1+f3= 1318.70 / 1187.99 =1.110

69
Spot/Forward rates
Example 2:
Two years from now, you intend to begin a
project that will last for 5 years. What
discount rate should be used when
evaluating the project?
2 year spot rate = 5% (risk adjusted)
7 year spot rate = 7.05% (risk adjusted)
(we should say “yield-to-maturity”)

70
Spot/Forward rates
Example 2:
Two years from now, you intend to begin a project that will last
for 5 years. What discount rate should be used when
evaluating the project?
2 year spot rate = 5% (is the same as 2 year yield-to-maturity)
7 year spot rate = 7.05% (is the same as 7 year yield-to-
maturity)
Answer: (1+ r7)7 = (1+ r2)2 (1+F(2,5))5

the forward rate is 
F(2,5)=[(1.0705)7/(1.05)2]1/5-1
= 7.88%
71
Spot/Forward rates
Example 3
8% 2 yr bond YTM = 9.43%
10% 2 yr bond YTM = 9.43%
What is the forward rate?
Step 1
value bonds 8% => 975
10%=> 1010
Define d1=1/(1+f1) and d2=1/(1+f1)(1+f2)
Step 2
975 = 80d1 + 1080 d2 -------> solve for d1
1010 =100d1 + 1100d2 -------> insert d1 & solve for d2

72
Spot/Forward rates
Example 3 continued
Step 3 solve algebraic equations

d1 = [975-(1080)d2] / 80
insert d1 & solve = d2 = .8350
insert d2 and solve for d1 = d1 = .9150
Step 4
Insert d1 & d2 and Solve for f1 & f2.
.9150 = 1/(1+f1) .8350 = 1 / (1.0929)(1+f2)
f1 = 9.29% f2 = 9.58%

73
the Forward Rate curve

The forward rate f(t,x) is the interest rate that can be contracted at time t for
instantaneously riskless borrowing or lending at time t+x.
It is a function or curve of the time-to-maturity x, which changes every day.
⇔
Spot rate:

74
Term Structure
Term Structure & Capital Budgeting
Ø Cash Flow should be discounted using Term Structure info
Ø Since the spot rate incorporates all forward rates, then you should
use the spot rate (YTM) that equals the term of your project.
Ø If you believe in other theories => take advantage of the
arbitrage.
What Determines the Shape of the Term Structure?

1 - Unbiased Expectations Theory: f2=E[r21]
2 - Market Segmentation Hypothesis (independent supply-demand
conditions in each bond maturity)
3 - Preferred Habitat Hypothesis
4 - Value-at-Risk of distribution of future spot rate
75
Expectation Hypothesis
❚ The Expectations Hypothesis --
The interest rate on a long-term
bond will be equal to the average
of short-term rates expected to
occur over the lifetime of the long-
term bond.
❚ Key assumption: Bonds of
different maturities are perfect
substitutes.
76
Expectation Hypothesis
❚ The downward sloping (inverted) yield curve is
unusual but not rare.
Fails to predict this occurrence.
(predicts 50-50 probability of upward vs downward
slope)
❚ Interest rates of bonds of all maturities move together
(are positively correlated)
Accurately predicts this occurrence. (bonds are
substitutes)
❚ The downward sloping (inverted) yield curve tends to
occur when interest rates in general are high.
Accurately predicts this occurrence

79
What’s Moving Interest Rates? level of new claims for unemployment insurance
http://krugman.blogs.nytimes.com/2011/01/19/whats-moving-interest-rates-2/
Paul Krugman
What’s Moving Interest Rates?
Think of an investor choosing whether to buy a 10-year bond or to keep her money parked in
short-term Treasuries. Abstracting from risk, she would choose whichever strategy is expected to
yield a higher return over the next decade — which means that she has to compare the actual
interest rate on 10-year bonds with the rates she expects to see on short-term assets over that
period.
But short-term interest rates are set by Fed policy; right now they’re more or less zero, but they
will rise eventually — and hopefully sometime within the next 10 years — when the economy
recovers sufficiently. So expectations about future short-term rates largely reflect beliefs about the
pace of recovery, and therefore of when the Fed will start to raise rates and by how much.
Hence the correlation visible in the figure above. The red line is the 10-year rate, the blue line the
level of new claims for unemployment insurance, a leading indicator for changes in the labor
market. UI claims are a pretty crude indicator of expected economic performance; even so, you
can see that 10-year rates plunged in the worst of the slump, when people thought we might
actually be seeing a second great depression; they rose as people started to think, well, maybe not;
they fell through much of 2010, as the recovery lost steam; and they’ve picked up somewhat
recently, as the data flow has looked somewhat better.
Paul Krugman
http://krugman.blogs.nytimes.com/2011/01/19/whats-moving-interest-rates-2/
80
81
Value-at-Risk of distribution of future spot rates

82
Value-at-Risk of distribution of future spot rates
A. Matacz and J.-P. Bouchaud, Explaining the forward interest rate term structure,

Phillips curve historical inverse relationship between rates
of unemployment and corresponding rates
of rises in wages
U.S. inflation and unemployment

Rate of Change of Wages against Unemployment, United
1/2000 to 8/2014
Kingdom 1913–1948 from Phillips (1958)
Average annual change of Unit Labor cost (y -axis) as a function of the average annual
change of the GDP deflator (x -axis) for 20 countries from 1970 to 2016.
Source: Ameco, own calculations.
Richard Senner and Didier Sornette, The Holy Grail of Crypto Currencies: Ready to replace fiat money? Journal of Economic Issues (in press) (http://
ssrn.com/abstract=3192924)
Knut Wicksell’s insight (1898)
At any given time, there are two interest rates:

1) the “natural” or optimum rate (which we can only infer)
2) the actual or market rate (which we can see).
When the market rate is set too low, capital misallocation emerges, leading to an
inflationary boom and inevitable subsequent bust.
When the market rate is set materially above the natural rate, the economy quickly
tanks and goes into a recession.
Good policy means keeping rates within the Wicksellian “optimum range”.
Wicksell’s thesis: if you want growth, you need to keep interest rates
above the average return on existing assets, and below the expected
marginal return on new assets.
THE REAL RISK-FREE RATE SINCE 1311, AND BOND BULL MARKETS
( Schmelzing, BoE, 2017)

RISK-FREE REAL RATE: CENTURY-, LINEAR-, AND 100-YEAR MOVING AVERAGES
( Schmelzing, BoE, 2017)

Loan rates and real interest rates
Schmelzing, Paul, Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018 (October 30, 2019).
Headline global real rate, GDP-weighted, and trend declines, 1317-2018
Nominal bond yields, GDP- and arithmetically-weighted, 1314-2018
Real long-term “safe asset” rates and composition by century, 1311-2018
Two approximations of the risk premium over time, 1317-1984
Global nominal interest rates and war frequency, 1495-2018
frequency of negative long-term real interest rates, as % share of DM GDP, 1313-2018
GavekalResearch
98
Modeling the Term Structure

ØAssumption 1: The spot rate r(t) follows a
diffusion process:
Ø Assumption 2: The price B(t,s) of a zero

coupon bond only depends on the value of
the spot rate r(τ), t≤τ≤s.
=> B(t,s) = B(t,s,r(t))
Ø Assumption 3: the market is perfect

99

ØDynamic of the zero-coupon bond:
µB(t,s,r(t)) B σB(t,s,r(t)) B
Recall the reasoning leading to the Ito term for the Black-
Scholes derivation of the value of the Call option:
Ito term
100

Ø Assume you issue an amount W1 of a zero-
coupon bond maturing at s1 and that you
buy an amount W2 of a zero-coupon bond
maturing at s2. The dynamic of your wealth
W=W2-W1 reads

101

Ø Consider now that you choose W1 and W2
such that:
 
the risky term in the dynamic of the wealth
W disappears:
(s2)

102

Ø In the absence of arbitrage opportunity, the
instantaneous rate of return of the previous
strategy must be equal to the risk free rate (spot
rate):
(s2)
or equivalently:
λ(t,r(t)) is the market price of risk

103

Ø Accounting for the fact that
B
and that µB(t,s,r)=r(t)+λ(t,r) σB(t,s,r), the value of

the zero coupon bond is solution of the PDE:

104

Example 1: one-factor Vasicek model
– The market price of risk is constant: λ(t,r)=λ
– The spot rate follows an Orstein-Uhlenbeck process:
– The term structure of the zero-coupon bond is:

105

– The YTM is:
•Normal Yield curve: 

R(t,T)
•Humped Yield curve: 
•Inverted Yield curve:
R∞
T
106

Example 2: Cox-Ingersoll-Ross
– The spot rate follows the process: Ensures the
positivity of r(t)

107

Example 2: Cox-Ingersoll-Ross
– The spot rate follows the process: Ensures the
positivity of r(t)
– The term structure of the zero-coupon bond is:

108

– The YTM is:
•Normal Yield curve: 

R(t,T)
•Humped Yield curve: 
•Inverted Yield curve:
R∞
T
109
Modeling the Forward Rate curve

The forward rate f(t,x) is the interest rate that can be contracted at time t for
instantaneously riskless borrowing or lending at time t+x.
It is a function or curve of the time-to-maturity x, which changes every day.
⇔
Spot rate:

F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, The
110
Relative Valuation of Caps and Swaptions: Theory and
Empirical Evidence, The Journal of Finance 56 (6),
2067-2109 (2002).

111
Modeling the Forward Rate curve

HJM
(Heath-Jarrow-Morton)
No-arbitrage condition leads to:
φ is the market
Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC price
Chair of Entrepreneurial of risks
Risks
112
A better model: the “String model”
P. Santa-Clara and
D. Sornette,
The Dynamics of
the Forward
Interest Rate Curve
with Stochastic
String Shocks,
The Review of
Financial Studies
14(1), 149-185
(2001)

113
Example: stochastic string shocks

114

115
String model for interest rate derivatives
Longstaff et al. (2001) have demonstrated the remarkable

modeling and predictive power of the « String model » for
pricing options on interest rates and bonds.
F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, Throwing away a billion

dollars: the cost of suboptimal exercise strategies in the swaptions market
Journal of Financial Economics 62, 39-66 (2001).
F.A. Longstaff, P. Santa-Clara and E.S. Schwartz, The Relative Valuation of Caps
and Swaptions: Theory and Empirical Evidence, The Journal of Finance 56 (6),
2067-2109 (2002)

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Financial Market Risks

Prof. Dr. Didier Sornette 1 D-MTEC Chair of Entrepreneurial Risks

ØValue of a bond and YTM (Yield-to-Maturity)

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Additional reading (https://xyotta.com)

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

ØThe simplest kind of bond is the Zero-

It is the Present Value (at t) of 1$ received at s.

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Ø The spot rate:

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

ØValue of a bond = Present value of its future

Yield-to-maturity (Internal Rate of Return)

Equivalence between continuous and discrete time discounting

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Impact of interest rates on bond price

Ø If r⇑, present value of future fixed payments⇓

Prof. Dr. Didier Sornette

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Debt & Interest Rates

Nominal Interest Rate = The rate you actually pay when

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Debt & Interest Rates

Real r is theoretically somewhat stable

Inflation is a large variable

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Term Structure and Yields

Consumer Price Index

three S-curve surges 1970-80

-4.0% per year

§ Expected returns on bills predict inflation

§ expected inflation predicts bill rates

Fama lecture on the history of the Efficient Market Hypothesis

D. Sornette – ETH Zurich – http://www.er.ethz.ch/

Prof. Dr. Didier Sornette D-MTEC Chair of Entrepreneurial Risks

Federal funds target rates

Prof. Dr. Didier Sornette D-MTEC Chair of Entrepreneurial Risks

Federal Funds Rate compared to U.S. Treasury interest rates

Prof. Dr. Didier Sornette D-MTEC Chair of Entrepreneurial Risks

Ø If r⇑, present value of future fixed payments⇓ 1

ØValue of a bond = Present value of its future

Yield-to-maturity (Internal Rate of Return)

with YTM = 7.5%)

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Ø A bond can be seen as a portfolio of zero-

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

– Invest $ CN-1xB(t,tN-1) at t " Receive $CN-1 at tN-1

Present value of the Payoff of the bond

In the absence of arbitrage opportunity, the knowledge of the price

ØTerm-structure: the sequence of bonds, yields, interest

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

x=0.92 => R=1/x-1 : Calculate R = 8.5%

Yield curve (Feb 2004)

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

Yield curve dynamics

Yield curve dynamics

Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks

1980 1990 2000 2010 2019

•Normal Yield curve: 