1 - Fixed-income instruments

Summary

At its simplest, an interest rate is the rate that is charged or paid for the use of money. It is often expressed as an annual percentage of the notional amount. Throughout the text we will generally focus on what are known as ‘interbank rates’. These are the interest rates at which banks borrow from and lend to each other in the interbank, or over-the-counter (OTC) market. The most important example of an interbank rate is the London Interbank Offered Rate, or LIBOR. The LIBOR rate is the interest rate at which banks offer to lend unsecured funds to each other in the London wholesale money market. Another related market rate is the swap rate, which is the fixed rate that a bank is willing to exchange for a series of payments based on the LIBOR rate.

In this chapter we present some basic terminology and definitions, together with an overview of fixed-income instruments such as forward rate agreements (FRAs), swaps, floating-rate notes and fixed-coupon bonds. Government-backed securities form another important class of interest rate instruments. In the USD market, securities such as Treasury bonds, Treasury notes and Treasury bills are issued by the US Treasury to finance government debt. All instruments are assumed to be default free, that is, we do not account for the possibility that the issuers may fail to honour their commitments.

We begin with the definition of the zero-coupon bond. Such bonds are not actively traded within the interbank market. The reason they are important, however, is because interbank interest rates such as LIBOR and swap rates can be defined in terms of zero-coupon bonds. The set of zero-coupon bonds for various time horizons is known as the zero-coupon curve. How the zero-coupon curve is estimated from market data such as LIBOR and swap rates is also discussed.

In this chapter, and indeed throughout this volume, time is measured in years.