Relationship between spot rates and short-term forward rates, Financial Management

Assume that an investor invests $X in a 3-year zero coupon Treasury security. Three years from now, the total return received would be:

         X ( 1 + y6)6

 The other alternative available to the investor is he could buy a 6-month treasury bill and reinvest the returns every six months for three years. The 6-month forward rate would decide the future return. An investment of Rs.A would generate a return equal to

         X (1 + y1) (1 + 1f1) (1 + 1f2) (1 + 1f3) (1 + 1f4) (1 + 1f5)                                                   

Since both investments must generate the same precedes an end of the investment horizon:

         X (1 + y6)6 = X (1 + y1) (1 + 1f1) (1 + 1f2) (1 + 1f3) (1 + 1f4) (1 + 1f5)     

Solving for 3-year spot rate,

         y6 = [(1 + y1) (1 + 1f1) (1 + 1f2) (1 + 1f3) (1 + 1f4) (1 + 1f5)]1/ 6 - 1                                  

In the above equation, we see that the 3-year spot rate depends on the current 6-month spot rate and the five 6-month forward rates. Actually, the right hand side of this equation is a geometric average of the current 6-month spot rate and five    6-month forward rates. In general, the relationship between a T-period spot rate, the current 6-month spot rate, and the 6-month forward rates is as follows:

         yT = [(1 + y1) (1 + 1f1) (1 + 1f2) (1 + 1f3) ..... (1 + 1fT - 1)]1/ T - 1

Thus, discounting at forward rates will give the same present value as discounting at spot rates.

Posted Date: 9/10/2012 2:43:50 AM | Location : United States







Related Discussions:- Relationship between spot rates and short-term forward rates, Assignment Help, Ask Question on Relationship between spot rates and short-term forward rates, Get Answer, Expert's Help, Relationship between spot rates and short-term forward rates Discussions

Write discussion on Relationship between spot rates and short-term forward rates
Your posts are moderated
Related Questions
What is meant by Leverage? What are its different types? With what type of risk is associated with each type of leverage. (Explain with illustration)

When a borrower uses repo market for fund financing, he has to deliver the securities to the lender. One way to do this is to deliver the collateral to the lender

Reconstruction and effect on share price A listed company facing reconstruction (divestment, demerger, MBO etc) will have informed the stock market in advance and the share pri

Chi Square Distribution If the difference between actual and the expected frequencies is zero, the sampling distribution of the chi square statistic c 2  will be identical to a

This is an individual assignment.  You are employed as a Trainee Accountant by Finners Accountants Ltd. The Finance Manager, Mr B Proudfoot has asked you to review details from

Explain how exchange rate fluctuations influence the return from a foreign market measured in dollar terms. Discuss the empirical proof on the effect of exchange rate doubt on the

International financial system has always been a debatable and crucial focus of the world discussion and it is mainly due to the repression of the economies especially after the cu

Q. Just-in-time inventory management processes? Just-in-time (JIT) inventory management processes seek to eliminate any waste that arises in the manufacturing process as a resu

Determine the Management buy-outs Management buy-outs (MBOs) The management of company buy out the shareholders. Management will usually require financial backers (ventu

Question: a. Le Mustang company Ltd is foreseeing a growth rate of 15 per cent per annum in the next three years. It is likely to fall to 12 per cent in the fourth year. Afte