What are spot rates? • Spot rates – the interest rate applicable for a specific period starting from today • Also known as zero coupon rates • Spot rate curve constructed from spot rates for various maturities • Spot rates are not directly observed in the market • Derived from the normal yield curve by the bootstrapping method What are forward rates? • Suppose an investor has a one-year investment horizon • He has 2 alternatives: ▪ Buy a 1-year Treasury Bill ▪ Buy a 6-month Treasury Bill and after it matures in six months, buy another 6-month T-Bill • The investor will be indifferent between the 2 alternatives when both alternatives give him the same return over his one year horizon • Investor knows the spot rates on the 6-month T-Bill and 1-year T-Bill • What will be the spot rate for a 6-month T-Bill purchased 6 months from now? Why compute forward rates? • Forward rates implied from current spot rates indicate the interest rates expected to prevail in the future • An investor’s strategy will depend on whether his expectations are different from that of the market • Example – An investor wants to invest Rs.50 lakhs for a one-year horizon – He can either invest directly for one year at the one-year spot rate or invest for six months at the 6-month rate and renew the deposit at the end of 6 months at the rate prevailing then – The six month spot rate is 7% and the one-year spot rate is 6% – This implies a rate of 5% for the six-month period starting 6 months from now – What will the investor do? Computation of forward rates When period is less than 1 year, the general formula is
Where rf is forward rate, rl =
long-term deposit rate, rs=short-term deposit rate, nl =number of days in long term, ns=number of days in short-term and nf=number of days in forward period Computation of forward rates When period is more than 1 year, the general formula is (1+rl)nl/12 = (1+rs)ns/12 * (1+f)nf/12 Where rl = rate for long period and nl =number of months in long period, rs = rate for short period and ns=number of months in short period, f =forward rate and nf =number of months in forward period An example
An investor has a 5-year investment
horizon. Should he (a) Invest in a 5-year bond or (b) Invest in a 2 year-bond today and roll over the maturity proceeds into a 3-year bond?
Investment for 5 years starting today will yield (1+.095)^5
Investment for 2 years starting today will yield (1+.088)^2 Investment for 3 years starting 2 yrs from now will yield (1+f)^(3) Hence f =(( (1+.095)^5)/((1+.088)^2))^(1/3)-1 The implied 3-year forward rate starting 2 years from now is 9.97% If the investor’s view is that the 3-year interest rate 2 years from now will be lower than 9.97%, he should go for (a) else go for (b) Forward Rate Agreements • A product to hedge against interest rate fluctuations for short periods • Can be used to lock in a rate of interest for a borrowing or investment for a fixed period starting n periods from now • Can be used for hedging against expected rise as well as decline in interest rates Mechanics of the FRA • The party with a long position enters into an agreement at time T0 to borrow from the party with the short position • a predetermined amount P • at a fixed interest rate k • for the period [T1, T2] • There is no exchange of principal at any time under the FRA • The difference between the reference rate at time T1 denoted by l and the agreed upon fixed rate k, if positive (negative), is received (paid) by the long position fro the short position • This difference is settled at time T1 by discounting the cashflows from T2 to T1 Pricing a new FRA • Pricing a new FRA - example • Suppose the current 3-month and 6-month LIBOR rates are 4% and 4.50%. Assuming that there are 92 days in the first 3-month period and 91 days in the second three-month period what is the price of a new 3 X 6 FRA? Valuing an existing FRA • FRA valuation example • Consider the 3X6 FRA of the earlier example. The principal amount is Rs.25,00,000. One month has passed since entering into the FRA. Assume that the current 2-month and 5-month interest rates are 5.50% and 6% respectively, what is the value of the FRA today? Assume that there are 61 days in the first two-month period and 91 days in the next three-month period. Borrower’s FRA • A company wants to borrow Rs.50 crore three months from now for a project which will take around 6 months. Its current borrowing cost is 9%. The Company anticipates the central bank to raise interest rates in December. The bankers are quoting a 3/9 FRA at 9.25%-9.75%. How can the Company hedge against the rise in interest rates? What will be the effective cost of borrowing for the Company if the interest rate is 10% at the end of three months from today? What if interest rate is at 8%? Investor’s FRA • A company expects a cash dividend of Rs.50 crore from its subsidiary three months from now. The CFO does not anticipate any requirement for these funds for a period of 6 months. Six-month bulk deposit rate is around 8.50% today. The CFO apprehends a decline in interest rates around December. The bankers are quoting a 3/9 FRA at 8.45%-8.75%. How can the Company hedge against a decline in interest rates? What will be the effective yield earned on the deposit if the interest rate is 8 % at the end of three months from today? What if interest rate is at 9%?
David R. Green, Alastair Owens, Josephine Maltby, Janette Rutterford - Men, Women, and Money - Perspectives On Gender, Wealth, and Investment 1850-1930 (2011, Oxford University Press)