Question

Define and Explain the following concepts (use secondary sources if needed):

a) Forward rate vs Spot rate
b) If the 5-year spot rate is 6% and 3-year spot rate is 4.5%, what is the 2-year (annualized)
forward rate 3 years from today? (use the idea developed in class)

Answer 1

a) Spot Rate: It is the price decided for settling transactions immediately. It is based on the value of assets at the time of the quote.  For example, Mike goes to buy 1kg of copper, the seller bids the price at $100. This is the spot rate or the spot price. If Mike decides to buy at this price the transaction is immediately settled.

Forward Rate: as the name suggests is the interest rate expected in the future. It is the calculated expectation of the yield on a bond, commodity or currency that will occur in the immediate future. It is applicable for transactions that will take place in the near future. For example, in the previous transaction if the seller feels that the market price for copper will go up in the future, and convinces Mike to book 1kg copper at $120 to be collected in one year when the price will be $150. In this case, $120 is the forward rate. This is a forward contract, whereby the buyer can book the product at a rate which is a little higher than spot rate (including the seller’s premium) also called the forward rate, and take the delivery later thus making profits from the then spot rate.

b) To calculate the one-year forward rate one year from now f(1,1),[ we use the below idea

Spot Rate for 5 years, S1 is 6%

   Spot Rate for 3 year S2 is 4.5%

N1= 5

N2= 3

F(1,1)= [(1 + S₁)ⁿ₁ / (1 + S₂)ⁿ₂]^1/(n₁^-n₂⁾ – 1

So, one-year forward rate one year from now is 8.29%