thisisbrianly

This is what I remember offhand.... Someone, please correct me if I am wrong.

Draw a time line.
Say I have 2 yr spot rate (current rate for 2 yrs loan) and 3 yr spot rate (current rate for 3 yrs loan) and I need a 1 yr forward rate, 2 yrs from now.

0_____ 1 yr______2 yrs _____3 yr


Go from now (t = 0) to t = 2 you need the 2 yr spot rate which you have.
From 2 yr to 3 yr you need a 1 yr forward rate (the rate applicable 2 yrs from now)

The combined effect of these two should be the 3 yr spot rate. (If I invest for 2 yrs and then re invest for 1 yr, it should be equal to me investing for 3 yrs right now.)

So (1 + 2yrs spot rate)(1+ 1 yr fwd rate 2 yrs from now) = (1 + 3 yrs spot rate)

The subscripts are there to make it more manageable... They don't have much to do with the concept per se.



Edited 1 time(s). Last edit at Wednesday, March 30, 2011 at 05:11PM by anish.