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Forward Rates

Forward Rates

• Forward interest rates are market’s consensus of future interest rates

Example of Forward rate

One year forward interest rate one year from now Six months forward interest rate six months from now

• When any two securities have same cash flows and face the same risk then they should have similar value

Calculating Forward Rates

• A bank plans to invest funds for one year

It can invest in say a one year Treasury security

Or it can invest in a six month treasury bill and reinvest post maturity for another six months

• Which strategy the investor shall decide upon

Calculating Forward Rates

S

T

A

R

T

One year

Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo
Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo
Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo
Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo
Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo
Calculating Forward Rates S T A R T One year 6 Mo Reinvest for 6 mo

6 Mo

Reinvest for 6 mo

Calculating Forward Rates

• The bank should be indifferent between the two rates if they give same value over the investment horizon

Example Let the principle investment be A The spot interest rate for six months be x 1

The spot interest rate for one year be x 2 The forward rate six months from now be f

Calculating Forward Rates

• The returns from the investment shall be

For six Months

A ( 1+ x 1 )

After reinvestment for one year

A ( 1+ x 1 )(1+f)

Calculating Forward Rates

• The returns from the investment shall be

For one year

A ( 1+ x 2 ) 2

Compounding is required as the coupon is semiannual

Calculating Forward Rates

• If the investor has to be indifferent between the two rates if they give same value over the investment horizon

A ( 1+ x 1 )(1+f)

= A ( 1+ x 2 ) 2

Calculating Forward Rates

• Thus forward rate is

f

=

2

[( 1+ x 2 ) / ( 1+ x 1 )] – 1

Calculating Forward Rates

• Validation of Formula

Invest in 6 mo T bill and reinvestment for another 6 months

A ( 1+ x 1 )(1+f)

= A*(1.1015)*(1.1018)

= 1.0333 A

Invest in a one year treasury bond

A ( 1+ x 2 )

2

= A (1.0165)

= 1.0333A

2

Spot rates and forward rates

• Presume and Investor plans to invest for three years • Alternatively he may invest in a 6 month treasury bill and fix up a forward rate for the balance period for reinvestment

Spot rates and forward rates

In case of Scenario 1 Total receipt would be X * ( 1+ Z6)

In case of Scenario 2

X*(1+Z1)*(1+F1)*(1+F2)*(1+F3)*(1+F4)*(1+F5)

Spot rates and forward rates

Thus if the forward rates are truly representative then X * ( 1+ Z6) =

X*(1+Z1)*(1+F1)*(1+F2)*(1+F3)*(1+F4)*(1+F5)

Or Z6 =

[(1+Z1)*(1+F1)*(1+F2)*(1+F3)*(1+F4)*(1+F5)]^(1/6) - 1

Spot rates and forward rates

• Let is take a scenario where we invest in a 1 year horizon

• Invest in a 1 year bond

2

A ( 1+ x 2 )

Or invest in 6 months treasury bill and rollover the investment for succeeding six months 3 times

= A (1+ X 1 ) (1+ 1 f 1 )

Spot rates and forward rates

• Thus

2

A ( 1+ x 2 ) = A (1+ X 1 ) (1+ 1 f 1 )

x 2 =

[(1+ X 1 ) (1+ 1 f 1 )]

1/2

-1

Valuation of Bonds through Forward Rates

• Any bond could either be valued by using the spot rates over the yield curve or initial spot rate plus forward rates

• This

be

shown

by

extending

can

our

understanding of the relationship between spot and forward rates as illustrated in previous slides

Calculating Forward Rates

• Conventionally we use t f m denotes t is the length of time that the interest rate refers to and m is when the forward rate begins

T f m = [( 1+ x m+t )

m+t

/ ( 1+ x m )

m

1/t

] – 1

Where t is 1 then it shall denote a six month spot rate Illustration : One year forward rate one year from now

Adapted from Fixed Income Reading Frank J Fabozzi Recommended Text

Thank You