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
In a putable bond, the bondholder has the right to force the issuer to pay off the bond prior to the maturity date. Let us consider the previous example with the

Peak Inc. needs to order Canadian raw materials to use in its production process. The Canadian exporter typically invoices Peak in Canadian dollars. Assume that the current exchang

Stock Market indicators: Stock indices can be organized by weighting the sample of stocks. The stock indicators can be of four types: price-weighted average, volume-weighted av

Explain Gresham’s Law. Answer:  Gresham’s law considers to the phenomenon that bad (abundant) money drives good (scarce) money out of circulation. This type of phenomenon was fre

These debentures are backed by integrity and creditworthiness. They do not have any specific collateral backing. Therefore, the ability of the issuing GSE to gene

R eceipt of bids and bid opening We discussed how to prepare the bids and to publish them in the earlier sub section. Now let us see how to receive and open bids. To receiv

Monte-Carlo Simulation Let us, for a shortwhile, leave the illustration for determining the price and consider a simpler illustration for understanding the Monte-Carlo method

Working capital cycle for a trade Inventories days (time inventories are held before being sold)   Plus   Trade receivables days (how long

When an investor buys a bond in between coupon payments, he is supposed to compensate the seller with the coupon interest earned on the bond from the last coupon

Q. What do you mean by Working Capital? Meaning of Working Capital:- Working capital management is a significant aspect of financial management. In business money is necessar