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How to Calculate Forward Rates from Spot Rates

The document explains how to calculate forward rates from spot rates using the no arbitrage condition. It provides an example comparing two investment choices: a direct 2-year bond and a combination of two 1-year bonds, demonstrating that their returns should be equal. The formula derived for calculating the one-year forward rate one year from now is f = (1+s2)²/(1+s1) - 1, with an example showing a forward rate of 7% based on given spot rates.

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Syed Taslim
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32 views

How to Calculate Forward Rates from Spot Rates

The document explains how to calculate forward rates from spot rates using the no arbitrage condition. It provides an example comparing two investment choices: a direct 2-year bond and a combination of two 1-year bonds, demonstrating that their returns should be equal. The formula derived for calculating the one-year forward rate one year from now is f = (1+s2)²/(1+s1) - 1, with an example showing a forward rate of 7% based on given spot rates.

Uploaded by

Syed Taslim
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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How to Calculate Forward Rates from

Spot Rates?
Once we have the spot rate curve, we can easily use it to derive the
forward rates. The key idea is to satisfy the no arbitrage condition – no
two investors should be able to earn a return from arbitraging between
different interest periods. Let’s take an example of how this works. Let’s
say an investor wants to invests his funds for two years. He is faced with
two choices:

1. Directly invest in a 2-year bond


2. Invest in a one-year bond, and again invest the proceeds after one
year in a one year bond.

Assuming the same nature of investments, the returns from both choices
should be the same.

Let’s say s1 is the one-year spot rate, s2 is the two-year spot rate and 1f1 is
the one year forward rate one year from now.

Assuming $1 as the initial investment, the value of investment in first


choice after two years:

= (1+s2)2

The value of investment in second choice after two years:

= (1+s1) (1+1f1)

If there are no arbitrage opportunities, both these values should be the


same.

(1+s2)2 = (1+s1) (1+1f1)

If we have the spot rates, we can rearrange the above equation to


calculate the one-year forward rate one year from now.

f = (1+s2)2/(1+s1) – 1
1 1

Let’s say s1 is 6% and s2 is 6.5%. The forward rate will be:

f = (1.065^2)/(1.06) – 1
1 1

f = 7%
1 1

Similarly we can calculate a forward rate for any period.

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