Calculation of instantaneous forward rate
Given a term structure of interest rates expressed in terms of discount factors Pi’s for time pillars t i’s,
where i=1 , … , n. The instantaneous forward rate at time t , f ( t ), is given by
−∂
f ( t )= ln P ( t ) ,
∂t
where P ( t ) is the discount factor for time t .
To calculate f ( t ), it is necessary to know the interpolation scheme by which P ( t ) is calculated.
Linear interpolation and flat extrapolation on zero rate
Let r i be the continuous compounded zero rate for time pillar t i, and r ( t ) be the continuous
compounded zero rate for time t such that
P ( t ) =exp (−r ( t ) ⋅t ) .
By the linear interpolation and flat extrapolation on zero rate,
{
r1 , t ≤ t1 ,
r i−r i−1
r ( t )= r i−1+ ( t−t i−1 ) ⋅ , t i−1 <t ≤ t i ,
t i−t i−1
rn , t>t n .
Given that
−∂ ∂ ∂
f ( t )= ln P ( t )= ( r ( t ) ⋅t )=r ( t ) +t ⋅ r ( t ) ,
∂t ∂t ∂t
the instantaneous forward rate is given by
{
r1 , t ≤ t 1,
r i−r i−1
f ( t )= r i−1 + ( 2 ⋅t−t i −1 ) ⋅ , t i−1 <t ≤t i ,
t i−t i−1
rn , t>t n .
Linear interpolation on discount factor
By the linear interpolation on discount factor,
Pi −Pi−1
P ( t ) =Pi−1+ ( t−t i−1 ) ⋅ ,
t i −t i−1
for t ∈ ( t i−1 , t i ] , where i=1 , … , n, and P0=1 .
Thus, for t ≤ t n,
−∂ −1 Pi−Pi−1
f ( t )= ln P ( t )= .
∂t P ( t ) t i−t i−1
For t >t n ,
f (t ) ≝ r n.
Linear interpolation on log-discount factor
Let l i be the log-discount factor for time pillar t i, and l ( t ) be the log-discount factor for time t such that
l ( t )=ln P ( t ) .
By linear interpolation on log-discount factor,
l i−l i−1
l ( t )=li−1 + ( t−t i−1 ) ⋅ ,
t i−t i−1
for t ∈ ( t i−1 , t i ] , where i=1 , … , n, and l 0=0 .
Thus, for t ≤ t n,
−∂ −l i−l i−1
f ( t )= l ( t )= .
∂t t i−t i −1
For t >t n ,
f (t ) ≝ r n.
