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
Q. Explain Traditional Method of Measurement? Computation of yield to measure a financial asset's return is the simplest and oldest technique of measurement. Yield can be find

Shareholders' wealth maximization Shareholders' wealth maximization refers to maximization of the net present value of every decision made in the firm. Total present value is e

There is some discussion on whether Multinational Corporations (MNC's) enhance risk when borrowing foreign currencies. Those in favor of borrowing state that lower costs of financi

Q. What do you mean by Variable working capital? Permanent or fixed: Permanent or fixed working capital is the minimum amount which is required to ensure effective utilization

What is Rationale and behind profitability maximisation Rationale & behind profitability maximisation, as a guide to financial decision making, is simple. Profit is a test of e

Enumerate the Securities and Investment Analysis Purchase of bonds, stocks and othersecurities involve analysis and techniques which are highly specialized. An investorshoul

what are the characteristics of relative cost

applicability of an operating cycle in vegetable growing in uganda

In the telecom industry of the Australia, these are some most important organizations such Vodafone Austrelia‎, TransACT Capital Communications, Optus, and Telstra. Vodafone A

Meaning merits nd demerits of modern approch of financial management