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

What is usual approach of capital structure, Q. What is usual Approach of c...

Q. What is usual Approach of capital Structure? Ans. Traditional Approach: - The traditional approach establishes middle among the Net Income approach and the Net Operating Inc

Working capital based on operating cycle, Q. Working Capital Based on Opera...

Q. Working Capital Based on Operating Cycle? The concept of operating cycle, helps determining The time scale over which the current assets are maintained. The operating cycle

zero salvage value, Big Joe's is changing a piece of equipment.  The equip...

Big Joe's is changing a piece of equipment.  The equipment will cost $5,000 and has a 5 year life.  The equipment can be leased for annual payment of $1,295 paid at the starting of

What is the expected return of cinderella''s portfolio, Question: Cinde...

Question: Cinderella invests the following sums of money in common stocks having the expected returns as detailed below: (a) What is the expected return of Cinderella's por

Paper on Estate Planning (3–5 pages), Evaluate the tools commonly used in e...

Evaluate the tools commonly used in estate planning, including trusts, life insurance, and annuities. Compare the tools as to how they would apply for a couple in their mid-50s who

Market, On January 1 a bond with face value of $1,000 is for sale in the ma...

On January 1 a bond with face value of $1,000 is for sale in the market.  That bond has a coupon rate of 6%, pays interest only once a year and the end of the year, and matures at

Financial management assignment, You have just had your 30 th birthday. Yo...

You have just had your 30 th birthday. You have two children. One will go to college 12 years from now and require four yearly payments for college expenses of RM11,000, RM12,000

Calculate the monetary performance of a firm, a) Year 2 ROCE = $400k / $1,0...

a) Year 2 ROCE = $400k / $1,000k = 40% Year 1 ROCE = $360k / $800k = 45% b) ROCE is an efficiency ratio that measures the monetary performance of a firm compared with the amo

What do you mean by shares, Q. What do you mean by Shares? Shares: issu...

Q. What do you mean by Shares? Shares: issue of the share is the most important source of the long terms capital. A company can issue various type of the share as the equity an

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