Spot and forward rates rates

islandgyrl

(1 + S3)^3 = (1 + 1f0)(1 + 1f1)(l + 1f2)

can someone explain this relationship. I don't understand the conceptual difference between spots and forwards. They seem like the same thing to me.

spartanag07

Let me try.

1. First, universally, it is very important to understand that all rates printed are annualized by default, unless otherwise mentioned specifically with that rate.

2. Spot rates, irrespective of their periods, are rates starting TODAY. Means,

1Y Spot rate - is the rate that you would apply on a Principal starting TODAY for 1 Year.
2Y Spot rate - is the rate that you would apply on a Principal starting TODAY for 2 Years.
3Y Spot rate - is the rate ....
and so on...

But, again, remember point 1. 3Y Spot rate would be given as an annualized rate.

3. Forward rates are rates with their STARTING point somewhere in future. e.g

1f1 - 1 year (or period) rate STARTING 1 year from now.
1f2 - 1 year (or period) rate STARTING 2 year from now.
1f0 - 1 year (or period) rate STARTING TODAY = 1Y SPOT Rate.

4. Next, is to understand that Spot Rate would account for all contiguous Forward Rates falling within its Period. e.g. 2Y Spot Rate would include/account for Forward Rates for 1 year starting today and for another year starting one year form today.

5. If point 4 is understood,
(1 + S3)^3 = (1 + 1f0)(1 + 1f1)(l + 1f2) is simply saying the same thing, only in the form of an equation. Where, S3 above is ANNULAIZED 3Y Spot Rate.

6. Last, I would suggest to always draw a time line to represent given Spot and Forward rates. That way, most of the confusion is cleared even before attempting the question.

Hope this helps.

invic

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I wanted to contact you, if that is okay with you. My email is srastogi999@gmail.com .

rgonzalez

Just emailed you bro.