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
Free Cash Flow Free cash flow presents the amount of cash generated by the existing operations of a corporation and that is not needed for reinvestment in new projects in the f

Pull Strategy Pull strategy define a marketing approach in which a manufacturer promotes a product directly to consumers in the hopes that the consumers will then request

Define the term- Profitability maximisation Profitability maximisation would imply that a firm must be guided in financial decision making by one test; select projects, assets

Q. Graphic Presentation of Organisation of Finance Function? Graphic Presentation of Organisation of Finance Function: - The following chart describes the organization of the f

How do tax considerations affect the cost of debt and the cost of equity? For the reason that interest on debt is tax deductible to the issuing firm, the higher the tax rate th

Definition of 'Beta' A measure of the volatility or systematic risk of a security or a portfolio in difference to the market as a whole. Beta is needed in the capital asset pri

I am facing some problems in my assignment on the topic Preliminary Screening. Can anybody suggest me the proper explanation for it?

What is Inherent risk Susceptibility  of  an  account  balance  or  class  of  transactions  to  material  misstatement either  individually  or  when  aggregated  with misstat

Trial Balances: If the trial balance does not result in a "0", the various records will need to be reviewed to pinpoint the spot where the unbalance occurred and any necessary

Government securities are the most important and unique financial instruments in the financial markets of any economy. Government of India Securities (GOI Sec) in