Computing forward rate, Financial Management

Assignment Help:

We can compute any forward rate using the spot rate. When we tell 3 years forward rate 4 years from now, there are two elements to consider. One is the length of the time for the rate, i.e., 3 years in our example and the second element is when in future the rate begins, and in our example it is 4 years. The notation used to represent the forward rate is l fn.

There are two subscripts in the notation. Subscript 'l' refers to the length of time in which the rate applies and the subscript 'n' refers to when the forward rate begins. 

Suppose an investor wants to invest Rs.100, and his investment horizon is l + n period.  The two options available to the investor are: purchase a zero-coupon bond with a maturity period of l + n or alternatively, purchase a zero-coupon bond with a maturity of l period and then reinvest the proceeds on maturity in a zero-coupon bond for n period. The investor will be indifferent towards the two alternatives if they produce the same return over the l + n investment horizon.

In the first option, the proceeds for this investment at the horizon date assuming that the semiannual rate is y l+n, will be

         $100 (1+ yl+n)l+n

For the second option, assuming that the semiannual rate is ym, the proceeds at the end of m periods will be,

         $100 (1+ ym)m

When the proceeds are received in m periods, they are reinvestment at the forward rate,  t fm, producing a value for the investment at the end of m + t periods of

         $100 (1+ ym) m (1+ t fm)t

The investor would be indifferent to the two alternatives when,

         $100 (1+ ym+t)m+t = Rs.100 (1+ ym) m (1+ t fm)t

Solving it for t fm,

         642_computing forward rate.png

If t is equal to 1, the formula reduces to the 1 period (6-month) forward rate.


Related Discussions:- Computing forward rate

Identify following belong income statement or the balance, Identify whether...

Identify whether the following items belong on the income statement or the balance sheet. a. Interest Expense IS                                      l. Cash BS b. Prefer

Price/yield relationship in bonds, Bond Price is the purchase value o...

Bond Price is the purchase value of a bond. It can be priced either at a premium, discount or at par. It is important for the prospective buyer to know how to det

Define stress testing and leverage, Lehman Brothers Holdings was a global f...

Lehman Brothers Holdings was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixedincome sale

Valuation and exit - hedge fund, Valuation and Exit Valuation: The Net ...

Valuation and Exit Valuation: The Net Asset Value is used as a base for ascertaining the prices applicable to investor subscriptions and redemptions. Fund administrator perform

Basic objectives of cash management, Q. Basic objectives of cash management...

Q. Basic objectives of cash management? The basic objectives of cash management are two-fold: 1) To meet the cash disbursement needs (payment schedule); and 2) To minimize f

Accounting system, Accounting System: The accounting systems are the pr...

Accounting System: The accounting systems are the primary financial systems that any business should have in place to ensure accurate and usable financial information. The b

FINA310-1203B-10 Financial Management, FINA310-1203B-10 Financial Managemen...

FINA310-1203B-10 Financial Management Assignment Name: Unit 2 Discussion Board Deliverable Length: 3-5 paragraphs Details: The Discussion Board (DB) is part of the core of online l

Volume of issues of central and state government securities, Volume of Issu...

Volume of Issues of Central and State Government Securities The growth of government securities market in India and the investor response to the government bond issues can be k

Discuss the pros and cons of financing in unhedged, You have the following ...

You have the following information about rates in London for Eurocurrency loans of one-year duration, the exchange rate between the USD and euros, the currency in which you want fi

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd