Zero coupon yield: Difference between revisions

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(Remove the material transferred to the new page Converting from zero coupon rates.)
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<span style="color:#4B0082">'''Example 1: Cash flows from 3-period zero coupon instrument'''</span>
<span style="color:#4B0082">'''Example: Cash flows from 3-period zero coupon instrument'''</span>


The zero coupon yield for the maturity 0-3 periods is 2% per period.
The zero coupon yield for the maturity 0-3 periods is 2% per period.
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If we know the zero coupon yield, we can calculate both the [[forward yield]] and the [[par yield]] for the same maturities and risk class.
If we know the zero coupon yield, we can calculate both the [[forward yield]] and the [[par yield]] for the same maturities and risk class.


The conversion process and calculation stems from the '[[no-arbitrage]]' relationship between the related yield curves. This means that the total cumulative cash flows from a two-year investment must be identical, whether the investment is built:
The conversion process and calculation stems from the '[[no-arbitrage]]' relationship between the related yield curves.  


* '[[Outright]]' from a two-year zero coupon investment
* Or as a [[synthetic]] deposit built using a forward contract, reinvesting intermediate principal and interest proceeds at a pre-agreed rate
* Or using a par investment, reinvesting intermediate interest to generate a total terminal cash flow
<span style="color:#4B0082">'''Example 2: Converting two-period zero coupon yields to forward yields'''</span>
Periodic zero coupon yields ('''z''') are:
z<sub>0-1</sub> = 0.02 per period (2%)
z<sub>0-2</sub> = 0.029951 per period (2.9951%)
The cash returned at Time 2 periods in the future, from investing £1m at Time 0 in a zero coupon instrument at a rate of 2.9951% per period, is:
£1m x 1.029951<sup>2</sup>
= £'''1.0608m'''
Under no-arbitrage pricing conditions, the identical terminal cash flow of £1.0608m results from investing in an outright zero coupon investment of one periods maturity, together with a forward contract for the second period - for reinvestment at the forward market yield of '''f<sub>1-2</sub>''' per period, as follows:
£1m x (1 + z<sub>0-1</sub>) x (1 + f<sub>1-2</sub>) = £'''1.0608m'''
Using this information, we can now calculate the forward yield for 1-2 periods' maturity.
1.02 x (1 + f<sub>1-2</sub>) = 1.0608
1 + f<sub>1-2</sub> = 1.0608 / 1.02
f<sub>1-2</sub> = (1.0608 / 1.02) - 1
= 1.04 - 1
= '''0.04''' per period (= 4%)
This is the market forward rate which we would enjoy if we were to pre-agree today, to make a one-period deposit, committing ourselves to put our money into the deposit one period in the future.
The no-arbitrage relationship says that making such a synthetic deposit should produce the identical terminal cash flow of £1.0608m. Let's see if that's borne out by our calculations.
Investing the same £1m in this synthetic two-periods maturity zero coupon instrument would return:
After one period: £1m x 1.02 = £1.02m
Reinvested for the second period at the pre-agreed rate of 0.04 per period for one more period:
= £1.02m x 1.04
= £'''1.0608m'''
''This is the same result as enjoyed from the outright zero coupon investment, as expected.


This is illustrated on the page [[Converting from zero coupon rates]].




Revision as of 09:06, 15 November 2015

The rate of return on an investment today, for a single cashflow at the final maturity of the instrument. No intermediate interest is payable or receivable. (There are no interest coupons, hence the name 'zero coupon'.)

The zero coupon yield is equal to the current market rate of return on investments in zero coupon bonds of the same maturity.


Example: Cash flows from 3-period zero coupon instrument

The zero coupon yield for the maturity 0-3 periods is 2% per period.

This means that a deposit of £1,000,000 at Time 0 periods on these terms would return:

£1,000,000 x 1.023

= £1,061,208 at Time 3 periods.

(No intermediate interest is payable.)


An application of zero coupon yields is the pricing of zero coupon bonds.


The zero coupon yield is also known as the Zero coupon rate, spot rate, or spot yield.


Conversion

If we know the zero coupon yield, we can calculate both the forward yield and the par yield for the same maturities and risk class.

The conversion process and calculation stems from the 'no-arbitrage' relationship between the related yield curves.


This is illustrated on the page Converting from zero coupon rates.


See also

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