Deriving 6-month forward rates, Financial Management

Assignment Help:

Using details from table 8, let us compute the 6-month forward rate. Simple arbitrage principle, like the one used to compute the spot rates are used in this process.

For example, let us consider an investor who has 1-year investment horizon and has two alternatives, (i) to buy a 1-year T-bill or (ii) to buy a 6-month T-bill; and when it matures after six months to buy one more 6-month T-bill. If both investments have the same cash flows and carry the same risk, then they will have same value. The investor will be indifferent towards the two alternatives if both of them produce same returns in the 1-year investment horizon. But, to compare both the options, the investor needs to know the forward rate on the 6-month Treasury bill to calculate the yield available on a 6-month treasury bill that will be purchased six months from now. Using the 6-month and 1-year Treasury bill spot rate, the six month forward rate on a 6-month treasury bill can be equated.

Let us now see how to determine the forward rate. Assume that an investor purchases a six month T-bill for $X. The value of the investment at the end of six months would be:

         X (1 + y1)

Where,

         y1 = One-half the Bond-Equivalent Yield (BEY) of the theoretical
            6-month spot rate.

Let us say f represents one-half the forward rate on a 6-month treasury bill available six months from now. The future returns that the investor would be receiving on his investment one year from now if he reinvests his investment by purchasing a six month treasury bill at the end of first six months, would be:

         X (1 + y1) (1 + f)

If we consider the alternative investment in 1-year T-bill and we assume that y2 represents one-half the BEY of the theoretical 1-year spot rate, then the total value of the investment at the end of one year would be:

         X (1 + y2)2

We know that the investor will be indifferent towards the two alternatives if he receives the same return. We can represent it with the help of following equations,

         X (1 + y1) (1 + f) = X (1 + y2)2

Solving for f,

          1639_6 month forward rate.png         

Now using the theoretical spot rates given in table 8, the 6-month and the 1-year
T-bill spot rate would be:

6-month bill spot rate = 0.0400, so y1 = $1.0200.

1-year bill spot rate = 0.0420, so y2 = $0.0210.

Substituting the values in equation (1) we get:

         2480_6 month forward rate1.png

So, the six month forward rate six months form now will be 4.4% (2.2% x 2) BEY. Now let us verify the values determined.  If $X is invested in the 6-month T-Bill at 2% and the proceeds are then reinvested for six months at the 6-month forward rate of 2.2% then the total return form this option would be,

         X(1.0200) x (1.0220) = 1.04244X

Now, if we invest the same amount i.e., $X in 1-year T-bill at one half the
1-year rate, 1.02105%, then return from this option would be,

         X (1.0210)2 = 1.04244 X

In a similar manner, 6 month forward rate beginning at any time period in the future can be calculated.  The notation we use to indicate 6-month forward rates is 1fm. In this, sub script 1 represents a 1-period (6-month) rate and subscript m represents the period beginning m period form now. When m is zero, then it represents current rate. Therefore, the first six months forward (1fm) rate is simply the current six month forward rate (y1).  The formula to determine a six month forward rate is:

         2438_6 month forward rate2.png


Related Discussions:- Deriving 6-month forward rates

Role of special purpose vehicle, The financial institutions tha...

The financial institutions that originate the loans sell a pool of cashflow-producing assets to a specially created third party that is called a

Leverage, what is the meaning of market feasibility? What are its different...

what is the meaning of market feasibility? What are its different types with their degree?

Leverage, evaluate the importance of leverage in a small scale companyestio...

evaluate the importance of leverage in a small scale companyestion..

Show the difference between revenues and costs, • Sales revenue line drawn ...

• Sales revenue line drawn and labelled correctly and accurately • Fixed cost line (at $1,020) labelled and drawn accurately and correctly • Total costs line (starting at $1,

Describe the external economies of scale, In the 2000s the German discount ...

In the 2000s the German discount chain Aldi began an expansion on the east coast of Australia. One strategy of Aldi is to encourage small retailers such as butchers, bakers, delica

CASE, How would you judge the potential profit of Bajaj Electronics on the ...

How would you judge the potential profit of Bajaj Electronics on the first year of sales to Booth Plastics and give your views to increase the profit.

The investment of public pension monies, Question: (a) The key determin...

Question: (a) The key determinants of investment decisions in the public sector are:- legal, political and financial factors. Show the importance of each determinant when de

Defqa, Ask question #Minimum 100 words acceptedaqs #

Ask question #Minimum 100 words acceptedaqs #

Explain the term- interest cover, Explain the term- Interest cover Int...

Explain the term- Interest cover Interest cover =Profit before interest and tax (PBIT)/ Interest payable(no. of times) Interest cover represents the safety of earnings tha

What is the usual pattern of cash flows, What is the usual pattern of cash ...

What is the usual pattern of cash flows for a share of preferred stock? How does the market determine the value of a share of preferred stock, given these promised cash flows?

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