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Pricing Treasury Bills

Pricing Convention:
• Priced at a discount from par or face value using the “true discount” formula and a 360-day
count. The “true discount” formula is just simple interest calculation in reverse
• Following market convention, how much of the annual yield you will actually earn is
directly proportional to the number of days (tenor) you are invested in a 360-day year. That is,
interest income is computed as: amount invested x annual yield x
• Final tax of 20% is paid upon purchase, i.e., front-loaded tax


Simple interest means that if you were to invest P 97,534.54 for 182 days at a quoted (before tax)
annual yield of 5%, you will earn an interest income of:

97,534.54 x 0.05 x = 2,465.46

So, after 182 days, you can expect to receive a total of P100,000 = 97,534.54 + 2,465.46

Investing in treasury bills means buying a future value (the face or par value). In our example, this
is the P100,000 we expect to receive in 182 days. Hence, T-bills are sold at a discount from par,
with the discount constituting your interest income. The formula for the discounted price
(97,534.54 in our example) is just simple interest calculation in reverse:

face value x 360 F x 360

D = discounted price = =
360 + yield x tenor 360 + Y x T

Philippine tax laws however impose a front-loaded final tax of 20% on interest or discount income.
Hence, the T-bill’s selling price (S) should include the tax:

S = D + 0.20 (F – D) and in our example S = 97,534.54 + 493.09 = 98,027.63

Notice that if the tax had been back-loaded as is the case with bank deposits, our after-tax yield
would have been: 4% = 5% (1 – 0.20). Paying the tax up front means that we lose interest that we
could have earned on the tax payment. Hence, our after-tax yield is only:
1,972 .37 360
3.98 % = 98 ,027 .63 x

Credits to Prof. R.C. Ybañez

Simplified T-Bill Formulas for Selling Price, Face Value and Yield

Selling Price
The multiple steps involved in determining a T-Bill’s selling price inclusive of tax can be simplified
in one formula:

F x (360 + Y x T x 0.2)
(360 + Y x T)

Given that face value is fixed, price is inversely related to yield, consistent
with the present value principle that the higher the discount rate, the lower is
present value.

At a yield of 5%, the P100,000 par, 182-day T-bill sells at 98,027.63.

At a higher yield of 6%, the same treasury bill should sell at a lower price of 97,644.68.
And at a lower yield of 4%, this treasury bill should sell at a higher price of 98,414.29.

Face Value (the Maturity Value)

S x (360 + Y x T)
(360 + Y x T x 0.2)

Many dealers allow clients to set the exact amount they wish to invest. For example, investors often
roll over all of the maturity value, i.e., “maximize” their investment. This could result in maturity
values that are fractions of the face values that T-Bills are typically denominated in (which are
round multiples of P1 million). This simply means that the investor will be part-owner of a mother
certificate with a face value that is a round multiple of P1 million.

Converting After-Tax Yield to Gross Yield

Credits to Prof. R.C. Ybañez

Some dealers prefer to quote after-tax yield to suit client preferences. To determine the equivalent
gross yield for comparability with yield quotations of other dealers:

360 x y
Y= where y is the after-tax yield
288 – y x T x 0.2


Simple buy-and-hold strategies involve a choice of tenors which are then held to final maturity.
Selling before maturity is not a deliberate part of the investment strategy.

In general:
• If rates are expected to increase, buy/invest in the short tenor
• If rates are expected to decrease, buy/invest in the long tenor

Suppose an investor has P100,000 available to invest for 203 days. Today's spot rates are 5.75% for
91-day T-bills, 5.85% for 112-day T-bills, and 6% for 203-day T-bills. The investor is considering
two investment options: initially invest for 112 days, then reinvest for 91 days; and an outright
purchase of a 203-day T-bill. Choosing the short tenor means accepting the lower rate but he
anticipates the 91-day T-bill rate to rise to from today’s spot rate to 6.4%. The shorter tenor may be
more profitable since he can subsequently reinvest at a higher rate.

The maturity value of a P100,000 112-day T-bill invested at today's spot rate is:

(360 + 0.0585 x 112) 100,000

= P101,450.72
(360 + 0.0585 x 112 x 0.2)

which maturity value, if reinvested for 91 days at the expected rate of 6.4%, yields :

(360 + 0.064 x 91) 101,450.72

= P102,759.48
(360 + 0.064 x 91 x 0.2)

For the alternative of investing in a 203-day T-bill :

(360 + 0.06 x 203) 100,000

= P102,688.47
(360 + 0.06 x 203 x 0.2)

Hence, based on the rate expectation, choosing the short tenor will earn an additional P71.01, and a
203-day yield of 6.16%, 16.0 basis points more than the 203-day spot rate of 6%.

Credits to Prof. R.C. Ybañez

Clearly, choosing the short tenor would yield more only if the 91-day rate increases to a level
sufficient to offset the term premium in spot rates, i.e., the 15 basis points that the spot 203-day rate
of 6% exceeds the spot 112-day rate of 5.85%. This "break-even" rate is called the FORWARD
RATE. In this case, the 91-day forward rate is 6.052%.

These transactions illustrate a decision to invest cash. However, the same considerations apply in a
choice to swap tenors, e.g., replacing a treasury bill of a short tenor with a T-bill of a longer tenor in
anticipation of a decline in interest rates.
The Implied Forward Interest Rate

The forward rate implied in the spot rates of two unequal tenors is illustrated below. Y1 is the annual
yield of the shorter tenor while Y2 is the annual yield of the longer tenor. The forward rate F2 is that
equivalent annual yield that will result in equal terminal values at time N2, where the maturity value
of the short tenor is ‘reinvested’ at F2 to from time N1 to time N2.

0 N1 N2
Y1 F2


In the case of T-bills, the implied forward rate can be determined using the formula:

360 x (M2 – M1)

F2 =
T x (M1 – 0.2 x M2)

where M2 = maturity value of the long tenor

M1 = maturity value of the short tenor
T = tenor corresponding to the forward rate (interval between N1 and N2)
(the formula assumes the same amount is invested at time 0 for the two tenors)

An alternative formula is:

C x 360
F2 = where C = (M2/M1 – 1)
T x (0.8 – 0.2 x C)

Credits to Prof. R.C. Ybañez

In the buy-and-hold example, the forward rate was viewed as the “break-even” rate between the
two strategies: the certain outcome for the long tenor, versus the uncertain outcome if the short
tenor is chosen, brought about by the uncertainty over the market yield at time N1 which yield will
determine the strategy’s final payoff at time N2.

The forward rate is also often referred to as the “lock-in” rate. The long tenor is in effect equivalent
to two sequential placements: the first at the spot rate Y1, and then a reinvestment to N2, but at an
assured rate. Choosing the long tenor over the short tenor eliminates the uncertainty about the
reinvestment yield by locking it in at the forward rate.

Yet another way to view the forward rate is that it reflects the market’s expectations about future
interest rates; specifically, the yield for tenor T expected to prevail at time N1. How so?

In the buy-and-hold illustration, the investor is expecting the 91-day T-bill rate to rise from today’s
spot rate of 5.75% to 6.4% in about 112 days time. He finds that investing in the shorter tenor and
subsequently reinvesting at the expected higher rate will be more profitable than buying outright a
203-day T-bill. In fact, he estimates that for as long as the 91-day T-bill rate will rise to a level
higher than the forward rate of 6.052%, a strategy of investing in the short tenor promises a higher
expected return.

Suppose other investors share his view that interest rates, particularly the 91-day T-bill rate, will
rise. These investors will likewise favor the shorter tenor, or if they are currently holding long
tenors, may even switch out of their current positions into the shorter tenors. If there are enough of
these investors, their transactions will tend to increase the demand for the shorter tenor, and reduce
that of the longer tenor. This will push up the price of the short tenors, i.e., reduce their yield. The
reduced demand for longer tenors will in turn lower their price and increase their yields.

As yields adjust in this manner, the forward rate must rise. In short, the forward rate will eventually
adjust to reflect market consensus on future interest rates.

But is the forward rate an unbiased estimate of market consensus about future interest rates? Not
quite, because other factors systematically affect the yield curve. For one, we know that the present
value of more distant cash flow is more sensitive to discount rate changes than that of nearer cash
flow. This means that for fixed-income securities, the longer the tenor of bills/bonds, the greater
their price sensitivity to changes in yields, i.e., the greater the price risk. And since investors
demand a premium for risk-taking, longer tenors will generally command higher yields than shorter
tenors, even in the absence of expectations of interest rate changes.1 Hence, the term premium
reflects both market expectations about future interest rates and a risk premium.

That’s why the yield curve is normally upward sloping.
Credits to Prof. R.C. Ybañez
We can safely say that the forward rate reflects market consensus about the future level of interest
rates, but we would need a more complex model of the yield curve to isolate that from the other
effects on the yield curve, e.g., the price risk premium.

Riding the Yield Curve (Tail-end Gapping)

Riding the yield curve is an investment strategy that requires selling T-bills before final maturity. It
utilizes the positive slope of a normal yield curve to enhance investor returns by taking advantage of
price increases (yield decreases) as the T-bill’s remaining tenor declines over the investor’s holding

An investor buys a T-bill with a tenor (say 273 days) longer than his planned holding period (say
182 days), and then sells on the day cash is needed (day 182) when its remaining tenor (91 days) is
now shorter. Riding down the yield curve in effect means riding up the price curve – buying at a
high yield (lower price) and eventually selling at a low yield (high price).

To illustrate, suppose the current yield curve has the following spot rates: 91 days at 5%; 182 days
at 5.5%; and 273 days at 6%.

Day 0 Day 182 Day 273

Buy a 273-day T-bill with a par of say, P1 million

− 965,184.12 6% 1,000,000

Sell it as a 91-day T-bill after 182 days

990,015.09 5% −1,000,000
The investor’s final cash flow will be:
− 965,184.12 990,015.09 for a yield of 6.402%

Compare this to a buy-and-hold strategy:

− 965,184.12 5.5% 986,535.37

Tail-end gapping generates a net advantage of P3,479.72, or an additional 90.2 basis points. Once
again, the break-even rate between the two strategies is the (91-day) forward rate.

The success of the strategy will however depend on:

• a stable, positive yield curve. The steeper the yield curve, the better. Stability is of course
not guaranteed and hence, the strategy bears the risk that the short tenor’s rate will rise and
prices will fall. Note that the buy-and-hold alternative strategy has no such price risk.

Credits to Prof. R.C. Ybañez

• transactions cost. The investor has to sell the T-bill and will incur transactions costs in the
form of a dealer’s spread. For the same tenor, e.g., 91 days, a dealer normally quotes buying and
selling rates – buy quotes at a higher yield (low price) and sell quotes at a lower yield (high
price). The yield differential is the dealer’s spread.

Spread Trading

Spread trading or rate anticipation swaps are relatively more complex and more risky strategies, but
can also offer greater rewards. Previous examples focused on yield changes of a single security.
Spread trading strategies focus on spread changes, which can be between tenors of the same
security class, two security classes of the same tenor, two currencies of the same tenor and security
class, etc.

The spread adjustment could occur via yield changes in one, or both of the securities. Thus, spread
trading strategies generally involve simultaneous buying (long) and selling (short) positions. The
investor buys the security whose price is expected to rise (yield to fall) and sells the security whose
price is expected to fall (yield to rise).

The first Gulf war in 1990 led to high volatility in oil prices and in FX and T-bills yields. The Dec.
28 yield curve showed a negative spread between short and long tenors: 91-day yield was at
35.154%, 182-day yield at 35.593%, and 31.112% for 364-day T-bills. Many expected the spread to
normalize once the Gulf crisis was resolved: the yield for the short tenor should fall relative to the
long tenor. A spread trading strategy would involve the following:

Day 0 Day 14 Day 182 Day 364

Sell a 364-day T-bill with a par of say, P1 million

808,560.83 31.112% − 1,000,000

Buy a 182-day T-bill:

− 808,560.83 35.593% 920,912.94

By the second week of January, the US coalition had won the war and global markets had begun to
normalize. Yields adjusted to 31.909% for the 168-day tenor and 31.546% for the 350-day tenor.
The investor can already profitably unwind his positions at this point.

Sell the 168-day T-bill:

Credits to Prof. R.C. Ybañez
825,426.21 31.909% − 920,912.94

Buy a 350-day T-bill:

− 812,230.58 31.546% 1,000,000

The investor’s final cash flow:

0 13,195.63 0 0

Note that over the 14-day holding period, the long position in 6-month T-bills resulted in an annual
yield of 67.4%, while the short position in 1-year T-bills resulted in a yield of −14.605%. The risk
of course is that the spread will move in the opposite direction.

Asset-Liability Strategies or Gapping

The price-yield relationship that is the basis for active asset management applies as well to
liabilities. Asset-liability investment strategies typically involve a deliberate tenor mismatch, or gap,
between assets and liabilities.

Suppose interest rates are expected to rise. We’ve seen that investors will prefer short tenors to be
able to reinvest at the higher rate, and to avoid the price loss from long tenors. On the liability side
however, we would prefer the long tenor to be able to lock in borrowings at today’s low interest
rate. This type of tenor or maturity mismatch is called a ‘positive gap’.

A ‘positive gap’ exists if the amount of assets that will mature or will be repriced exceeds the
amount of liabilities that will mature or will be repriced over a particular time period. A gap is
necessarily defined over a particular time frame, e.g., over the next 12 months, as the type of gap
could vary over different time intervals.

A ‘negative gap’ is the reverse, maturing (or repricing) assets are less than the maturing (or
repricing) liabilities. When interest rates are expected to fall, investors prefer to invest in long tenors
and borrow in the short tenor. Note that ‘riding the yield curve’ is a form of negative gapping.

A zero gap or ‘square position’ means there is no mismatch in assets and liabilities.

Gapping strategies seek to maximize the profit potential from expected interest rate or yield
changes, but it can also be quite risky. A positive gap is driven by expectations of rising interest
rates, but if rates move in the opposite direction, declining interest rates would mean the investor is
forced to reinvest in low yield assets and may end up locked in at high borrowing costs. Note

Credits to Prof. R.C. Ybañez

further that if the yield curve is positively sloped, a positive gap means that the investor’s asset-
liability position will initially carry a low or even negative spread.

Effective execution of gapping strategies requires that both assets and liabilities are in relatively
liquid securities. Hence, gapping is typically exercised by financial institutions that have ready
access to financial markets and have the ability to quickly reverse or unwind asset-liability positions
that have become exposed to changing interest rate directions.

Financial prudence suggests that non-financial corporations, which have mainly illiquid real assets,
should generally aim for maturity matching.

Illustration of Gapping

We illustrate the possible outcomes of gapping strategies for a financial institution (FI). Many FI’s
earn a good part of their profits by lending/investing, earning a spread over borrowed funds. In this
illustration, we assume a normal spread of 400 basis points and a conservative debt-equity ratio of
4:1. To simply the arithmetic, we assume zero taxes and simple interest calculation over a 364-day
year. The FI expects interest rates to drop by 200 basis points in six months time:

Current Yield Curve Expected Yield Curve

Tenor Loans Borrowings Loans Borrowings

182 15% 11% 13% 9%
364 17% 13% 15% 11%

Full Year Full Year

Balance Sheet Income(Expenses) ROE

Consider first the full year results of a square position, e.g., 1-year loans and borrowings:

Loans 100,000 17,000

Borrowings 80,000 (10,400)
Equity 20,000 6,600 33.0%

Given the expectation of declining interest rates, a more aggressive FI will go for a negative gap,
i.e., 1-year loans and 6-month borrowings:

Loans 100,000 17,000

Borrowings 80,000 (8,198)
Equity 20,000 8,802 44.0%

Credits to Prof. R.C. Ybañez

On the other hand, consider the downside risk of an FI who misread the direction of interest rates
and erroneously positioned itself (i.e., through a positive gap of 6-month loans and 1-year

Loans 100,000 14,488

Borrowings 80,000 (10,400)
Equity 20,000 4,408 20.4%

Credits to Prof. R.C. Ybañez