Chapter 6: YIELD MEASURES, SPOT RATES, AND FORWARD RATES

1. Sources of Return

When an investor purchases a fixed income security, he or she can expect to receive a dollar return from one or more of
the following sources:

1. When an investor purchases a fixed income security, he or she can expect to receive a dollar return from one or
more of the following sources:
2. When an investor purchases a fixed income security, he or she can expect to receive a dollar return from one or
more of the following sources:
3. income from reinvestment of interim cash flows (interest and/or principal payments prior to stated maturity)

A. Coupon Interest Payments

✓ The most obvious source of return on a bond is the periodic coupon interest payments. For zero-coupon instruments,
the return from this source is zero. By purchasing a security below its par value and receiving the full par value at
maturity, the investor in a zero-coupon instrument is effectively receiving interest in a lump sum.

B. Capital Gain or Loss

✓ An investor receives cash when a bond matures, is called, or is sold. If these proceeds are greater than the purchase
price, a capital gain results (i.e., purchased at a discount). For a bond held to maturity, there will be a capital gain if
the bond is purchased below its par value. For example, a bond purchased for $94.17 with a par value of $100 will
generate a capital gain of $5.83 ($100−$94.17) if held to maturity.
✓ For a callable bond, a capital gain results if the price at which the bond is called (i.e., the call price) is greater than
the purchase price. For example, if the bond in our previous example is callable and subsequently called at $100.5,
a capital gain of $6.33 ($100.50 − $94.17) will be realized.
✓ If the same bond is sold prior to its maturity or before it is called, a capital gain will result if the proceeds exceed
the purchase price. So, if our hypothetical bond is sold prior to the maturity date for $103, the capital gain would be
$8.83 ($103 − $94.17)
✓ Similarly, for all three outcomes, a capital loss is generated when the proceeds received are less than the purchase
price. For a bond held to maturity, there will be a capital loss if the bond is purchased for more than its par value
(i.e., purchased at a premium).

C. Reinvestment Income

✓ Prior to maturity, with the exception of zero-coupon instruments, fixed income securities make periodic interest
payments that can be reinvested. The interest earned from reinvesting the interim cash flows (interest and/or
principal payments) prior to final or stated maturity is called reinvestment income. This is also called interest-on-
interest.
✓ For amortizing security, reinvestment income is the interest income generated from reinvestment of coupon and
periodic principal repayment before the maturity date.

[[[ More related discussion from slide is added at last of this chapter ]]]

Q: What is Yield?

The yield of an investment is the interest rate that will make the present value of the cash flows from the investment
equal to the price or cost of the investment. The yield is also called the internal rate of return.
2. Traditional/Conventional Yield Measures

A. Current Yield

The current yield relates annual coupon to the market Current yield vs Coupon rate:
price of the bond. It only considers the annual coupon ✓ Bond sells at a discount : CY > CR
and no other factor that may influence the yield. ✓ Bond sells at a premium: CY < CR
✓ Bond sells at par : CY = CR

For example, the current yield for a 7% 8-year bond Drawbacks:

whose price is $94.17 is 7.43% as shown below: ✓ It considers only the coupon interest and no other
source for an investor’s return.
✓ No consideration is given to the capital gain an investor
will realize when a bond purchased at a discount is held
to maturity; nor is there any recognition of the capital
loss an investor will realize if a bond purchased at a
premium is held to maturity.
✓ No consideration is given to reinvestment income.

B. Yield to Maturity

• YTM is the average rate of return available from bond investment if the bond is held till maturity. If coupons are
paid semiannually, then semiannual yield to maturity will be determined. The practice is to double the semiannual
yield to maturity in order to determine annual yield to maturity. The yield to maturity computed using this
convention—doubling the semiannual yield—is called a bond-equivalent yield.

• In general, when one doubles a semiannual yield (or a semiannual return) to obtain an annual measure, one is said
to be computing the measure on a bond-equivalent basis. The yield to maturity or the bond-equivalent yield is less
than the effective annual yield.

• The following relationships between the price of a bond, coupon rate, current yield, and yield to maturity hold:

• Advantages:
o The yield to maturity considers not only the coupon income but any capital gain or loss that the investor will
realize by holding the bond to maturity.
o The yield to maturity also considers the timing of the cash flows.
o It does consider reinvestment income; however, it assumes that the coupon payments can be reinvested at an
interest rate equal to the yield to maturity. So, if the yield to maturity for a bond is 8%, for example, to earn
that yield the coupon payments must be reinvested at an interest rate equal to 8%.

• The investor will only realize the yield to maturity stated at the time of purchase if the following two assumptions
hold:
o Assumption 1: the coupon payments can be reinvested at the yield to maturity
With respect to the first assumption, the risk that an investor faces is that future interest rates will be less than
the yield to maturity at the time the bond is purchased, known as reinvestment risk.
o Assumption 2: the bond is held to maturity
If the bond is not held to maturity, the investor faces the risk that he may have to sell for less than the purchase
price, resulting in a return that is less than the yield to maturity, this is known as interest rate risk.
 Factors affecting the reinvestment risk
There are two characteristics of a bond that affect the degree of reinvestment risk:

i) Characteristic 1: For a given yield to maturity and a given non-zero-coupon rate, the longer the maturity,
the greater the reinvestment risk (that means, the more the bond’s total dollar return depends on
reinvestment income to realize the yield to maturity at the time of purchase)

ii) Characteristic 2: For a coupon paying bond, for a given maturity and a given yield to maturity, the higher
the coupon rate, the greater the reinvestment risk (that means, the more dependent the bond’s total dollar
return will be on the reinvestment of the coupon payments in order to produce the yield to maturity at the
time of purchase)

This means that holding maturity and yield to In contrast, a bond selling at a discount will be less
maturity constant, bonds selling at a premium dependent on reinvestment income than a bond selling
will be more dependent on reinvestment at par because a portion of the return is coming from the
income than bonds selling at par. This is because capital gain due to accretion of the discount price when
the reinvestment income has to make up the holding the bond to maturity. For zero-coupon bonds,
capital loss due to amortizing the premium price none of the bond’s total amount of return is dependent on
when holding the bond to maturity. reinvestment income. So, a zero-coupon bond has no
reinvestment risk if it is held till maturity. Therefore,
মানে হন া, প্রিপ্রময়ানম সে করা বনের িাইজ (১০৫ টাকা) যতই yield earned on a zero-coupon bond held to maturity is
সমচ্যুপ্ররটিনত যায় ততই পার ভ্ুা য এর েমাে (১০০ টাকা) হনয় যায়। equal to the promised yield to maturity.
ফন at maturity, ইেনভ্স্টনরর ৫ টাকা Capital Loss হয়।
মানে হন া, প্রিস্কাউনে সে করা বনের িাইজ (৯৫ টাকা) যতই সমচ্যুপ্ররটিনত যায়
আর এই Capital Loss সক কমনপনেট করার জেু
ততই পার ভ্ুা য এর েমাে (১০০ টাকা) হনয় যায়। ফন at maturity,
Reinvestment Income অবশ্ুই সবপ্রশ্ হনত হনব। আর এই
ইেনভ্স্টনরর ৫ টাকা Capital Gain হয়। তাই ইেনভ্স্ট্রনক Reinvestment
জেুই প্রিপ্রময়ানম সে করা বনের Reinvestment Risk পার বে
Income এর উপর অত সবপ্রশ্ প্রিনপনেে হনত হয় ো। আর এই জেুই প্রিস্কাউনে
সেনক সবপ্রশ্ হনয় োনক।
সে করা বনের Reinvestment Risk পার বে সেনক কম হনয় োনক।

C. Yield to Call

• When a bond is callable, the practice has been to calculate a yield to call as well as a yield to maturity. A callable
bond may have a call schedule (it shows the call price that the issuer must pay based on the date when the issue is
called). The yield to call assumes the issuer will call a bond on some assumed call date and that the call price is the
price specified in the call schedule
• Typically, investors calculate a yield to first call or yield to next call, a yield to first par call, and a yield to refunding.
- Yield to first call is computed for an issue that is not currently callable.
- Yield to next call is computed for an issue that is currently callable.
- Yield to refunding is calculated assuming the issue will be called on the first refundable date.

Yield to refunding is used when bonds are currently callable but have some restrictions on the source of funds used to
buy back the debt when a call is exercised. E.g. if a debt issue contains some refunding protection, bonds cannot be
called for a certain period of time with the proceeds of other debt issues sold at a lower cost of money. As a result, the
bond holder is afforded some protection if interest rates decline and the issuer can obtain lower-cost funds to pay off the
debt. It should be noted that the bonds can be called with funds derived from other sources (e.g., cash on hand) during
the refunded-protected time period. The refunding date is the first date the bond can be called using lower-cost debt.

D. Yield to Put

A putable issue has a put schedule which specifies when the issue can be put and the put price. When an issue becomes
putable, the yield to put can be computed. The yield to put is the interest or discount rate that makes the total present
value of the projected cash flows to the assumed put date and the put price on that date as per the put schedule equal to
the price of the bond. The yield to put can be calculated the same process as the yield to maturity or yield to call.

E. Yield to Worst

• A yield can be calculated for every possible call date and put date. In addition, a yield to maturity can be calculated.
The lowest of all these possible yields is called the yield to worst.

• For example, suppose that there are only four possible call dates for a callable bond, that the yield to call assuming
each possible call date is 6%, 6.2%, 5.8%, and 5.7%, and that the yield to maturity is 7.5%. Then the yield to worst
is the minimum of these yields, 5.7% in our example.

F. Cash Flow Yield

• The cash flows or installments of amortizing securities (mortgage-backed securities, asset-backed securities etc.)
consist of three components i) coupon, ii) scheduled principal repayment, and iii) prepayments. For these securities,
cash flow yield is computed.

• The cash flow yield is the interest rate or the discount rate that makes the total present value of the projected cash
flows equal to the current market price. The difficulty in calculation is to forecast the amount of prepayment in each
time period

G. Yield to Portfolio

• First, the cash flows of the bond portfolio is determined. The yield of a portfolio is the interest or the discount rate
that equates the total present value of the cash flows to the current market value of the bond portfolio.

H. Yield Spread/Margin Measures for Floating-Rate Securities

• The coupon rate for a floating-rate security (or floater) changes periodically according to a reference rate (such as
LIBOR or a Treasury rate). Since the future value for the reference rate is unknown, it is not possible to determine
the cash flows. This means that a yield to maturity cannot be calculated. Instead, ‘‘margin’’ measures are computed.
Margin is simply some spread above the floater’s reference rate.

• Several spread or margin measures are routinely used to evaluate floaters which include simple margin or spread
for life, adjusted simple margin, adjusted total margin, and discount margin. Two margin measures commonly used
are spread for life and discount margin.

Discount margin

✓ Discount margin estimates the average margin over the reference rate that the investor can expect to earn over the
life of the security.

✓ The procedure for calculating the discount margin is as follows:

- Step 1: Determine the cash flows assuming that the reference rate does not change over the life of the security.
- Step 2: Select a margin.
- Step 3: Discount the cash flows found in Step 1 by the current value of the reference rate plus the margin
selected in Step 2.
- Step 4: Compare the present value of the cash flows as calculated in Step 3 to the price plus accrued interest. If
the present value is equal to the security’s price plus accrued interest, the discount margin is the margin assumed
in Step 2. If the present value is not equal to the security’s price plus accrued interest, go back to Step 2 and try
a different margin.
✓ For a security selling at par, the discount margin is simply the quoted margin in the coupon reset formula.

✓ Example: (@khata)
For the five assumed margins, the present value is equal to the price of the floating-rate security ($99.3098)
when the assumed margin is 96 basis points. Therefore, the discount margin is 96 basis points. Notice that the
discount margin is 80 basis points, the same as the quoted margin, when this security is selling at par ($100).

✓ Two limitations or drawbacks:

- First, the measure assumes that the reference rate will not change over the life of the security.
- Second, if the floating-rate security has a cap or floor, this is not taken into consideration.

More discussion from slide

 Interest on Interest Return in Amount

• The potential total return in amount from coupon and interest on interest can be computed by applying the future
value of annuity formula.
• Total coupon plus interest on interest constitute the total return in amount. From this amount if the amount of
total coupon is subtracted, then the amount of interest on interest will be determined. (See the method_1 of
determining the reinvestment income under the example of YTM above)

 YTM and Reinvestment Risk

• An investor will realize the yield to maturity at the time of bond purchase only if the bond is held till maturity
and the coupon payments can be reinvested at the computed yield to maturity.
• There are two bond characteristics that determine the extent of reinvestment risk – one is the maturity and the
other is coupon. (Discussed above)

 Cash Flow Yield and Reinvestment Risk

• The reinvestment risk is even greater for amortizing securities. The reason is that, in addition to the periodic
coupon, the periodic principal repayments must be reinvested. Besides, in case of some amortizing securities
payments are made monthly. The more frequent payments increase the reinvestment risk further.
• Usually, the borrower prepays the principal when interest rates decline. This further increases the reinvestment
risk as the prepaid principal must be invested at lower rate.

 Total Return:
• It is difficult to determine the best investment alternative out of several bond investment opportunities, keeping in
view the investment horizon of the investor, on the basis of yield to maturity or yield to call because of some
problems inherent in the measures.
• However, the total rate of return measure does not involve those problems and can be applied to determine the best
bond investment alternative for the investor on the basis of the investor’s personal expectations.

 Total Rate of Return:

• The total rate of return is a measure of yield that incorporates an explicit assumption regarding the reinvestment
rate.
• First, it computes the total future cash flows that will result from bond investment assuming a particular
reinvestment rate.
• The total return is then determined as the interest rate that will make the initial investment grow equal to the
computed total future cash flows.
 • The total future cash flows are calculated on the basis of the assumed reinvestment rate considering the periodic
coupons and interest-on-interest component for the investment horizon and the par value or the bond value as
computed on the basis of the market yield at the end of the investment horizon.
• 2ta Example @khata

 Horizon Analysis
• The use of total rate of return to assess bond performance over some investment horizon is called horizon
analysis. When total return is computed over an investment time period, it is referred to as horizon return. The
terms total return and horizon return are frequently used interchangeably.
• Horizon return is also used in evaluating bond swaps. In bond swap, bond held in the portfolio is replaced with
another bond on the basis of the total return.
• Often cited as the limitations of the total return measure that it requires to formulate assumptions regarding
reinvestment rate and future yields as well as to perform analysis in terms of an investment horizon. However,
the horizon analysis framework helps in analyzing bond performance under different yields and reinvestment
rates scenarios and in understanding the sensitivity of the bond performance under each scenario.

 Calculation of yield change

When interest rates or yields change between two time periods, there are two ways, in practice, the change is
calculated:
(1) The absolute yield change: The absolute yield or rate change is measured in basis points and is simply the
absolute value of the difference between the two yields.
Absolute yield change = |initial yield – new yield| x 100

(2) The percentage yield change: The percentage yield change is calculated as the natural logarithm of the ratio of
the yield change as follows (ln is the natural logarithm):
Percentage yield change = 100 x ln (new yield / initial yield)

3. Treasury Yield Curve

The relationship between yield and maturity of on-the-run Treasury securities is displayed in the following table. The
relationship shown is called the Treasury yield curve—even though the ‘‘curve’’ shown is presented in tabular form.

Issue (maturity) Yield (%) Treasury Yield Curve

1 month 1.68
3 months 1.71
Yield (%)
6 months 1.81
5.38

6
4.88

1 year 2.09
4.18

2 years 2.91 5

5 years 4.18 4
2.91

10 years 4.88 3
2.09
1.81
1.71
1.68

30 years 5.38 2

1
[[Note: Blue rows indicate the
yield on zero coupon bond having 0
2 years

5 years
3 months

6 months

1 year

10 years

30 years
1 month

a maturity of ≤1 year. Rests are the

yields on coupon bearing bonds.]]
 The information presented indicates that the longer the maturity the higher the yield and is referred to as an upward
sloping yield curve. Since this is the most typical shape for the Treasury yield curve, it is also referred to as a normal
yield curve. Other relationships have also been observed. An inverted yield curve indicates that the longer the
maturity, the lower the yield. For a flat yield curve, the yield is approximately the same regardless of maturity.

Treasury yield curve: The Treasury yield curve (also known as the term structure of interest rates) draws out a line
chart to demonstrate a relationship between yields and maturities of on-the-run Treasury fixed-income securities. It
illustrates the yields of Treasury securities at fixed maturities, viz. 1, 2, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and
30 years.
On-the-run Treasury securities: On-the-run Treasuries are the most recently issued/ most commonly treaded
Treasury bonds or notes of a particular maturity. The on-the-run Treasury is significantly more liquid than other forms
of securities.
Off-the-run Treasury securities: It refer to Treasury securities that have been issued before the most recent issue
and are still outstanding.

To get a yield for maturities where no on-the-run

Treasury issue exists, it is necessary to interpolate from
the yield of two on-the-run issues. Thus, when market
participants talk about a yield on the Treasury yield
curve that is not one of the available on-the-run
maturities—for example, the 8-year yield—it is only an
approximation.

✓ It is critical to understand that any non-treasury (coupon bearing securities) issue must offer a premium above the
yield offered for the same maturity on-the-run Treasury issue. How much greater depends on the additional risks
(like default risk, liquidity risk etc.) associated with investing in that particular non-treasury issue. Even off-the-
run Treasury issues must offer a premium to reflect differences in liquidity.

✓ Limitations: The quoted yields may not reflect the true yields and there exists reinvestment risk and interest rate
risk in case of on-the-run Treasury issues.
✓ Because of the above problems, when market participants talk about interest rates in the Treasury market and use
these interest rates to value securities, they look at another relationship in the Treasury market: the relationship
between yield and maturity for zero-coupon Treasury securities.

✓ However, zero-coupon Treasury securities with maturity greater than one year are not issued. As such, government
dealers synthetically create zero-coupon securities – the process is known as stripping of Treasury security and
the securities are called Treasury strips. Because zero-coupon instruments have no reinvestment risk, Treasury
strips for different maturities provide a superior relationship between yield and maturity than do securities of on-
the-run Treasury yield curve.
✓ Another advantage is that the duration of a zero-coupon security is approximately equal to its maturity.
Consequently, bonds can be compared on the basis of duration against Treasury strips. The yield on a zero-coupon
security has a special name: the spot rate. In case of a Treasury security, the yield is called a Treasury spot rate.
The relationship between maturity and Treasury spot rates is called the term structure of interest rates.
4. Spot rate

The price of a bond is the sum of the present values of its cash flows. In discounting the cash flows the discount rate
used should be the yield on a Treasury security with the same maturity plus a spread or margin that is appropriate with
the risk. However, there is a problem with using Treasury yield curve to determine the appropriate yield or discount
rate. The following example illustrates the problem:

The two hypothetical 5-year Treasury bonds A and B have coupon rates of 12% and 3% respectively. Therefore, the
semiannual cash flows are as follows:

Bond A Bond B
CF in time period 1-9 6 1.5
CF at time period 10 106 101.5

Because the cash flows are occurring at different points in time, as such, it is incorrect to use the same interest rate for
discounting all the cash flows. Instead, each cash flow should be discounted by a unique interest rate appropriate for
the time in which the cash flow is occurring. The correct approach is to consider the bonds A and B as packages of cash
flows i.e., packages of zero-coupon instruments. Therefore, the amount of interest is the difference between maturity
value and the price paid.

Bond A can be viewed as 10 zero-coupon bonds one with a maturity value of 6 maturing 6 months from now, a second
with a maturity value of 6 maturing 12 months or 1 year from now, a third with a maturity value of 6 maturing 18 months
or 1½ years from now & so on. The same is the case with Bond B. Therefore, the value of the bonds should equal the
total value of all the component zero-coupon bonds. Otherwise, arbitrage profit can be made.

To determine the value of each zero-coupon bond it is necessary to know the yield on a zero-coupon Treasury with
the same maturity. This yield is called the Treasury spot rate and the graphical depiction of the relationship between
the spot rate and maturity is called the Treasury spot rate curve. As there are no zero-coupon Treasury debt issues
with a maturity greater than one year, it is not possible to construct such a curve solely from observations of market
activity on Treasury securities. Rather it is necessary to derive the curve from theoretical considerations as applied to
the yields of the actually traded Treasury debt securities. Such a curve is called a theoretical spot rate curve and is the
graphical depiction of the term structure of interest rate.

 Development of Theoretical Spot Rate Curve for Treasuries

A default-free theoretical spot rate curve 1) on-the-run Treasury issues

can be constructed from the yield on 2) on-the-run Treasury issues and selected off-the-run Treasury
Treasury securities. The Treasury issues issues
that can be considered are: 3) all Treasury coupon securities and bills
4) Treasury coupon strips

In the following, two methods of developing theoretical spot rate curve considering the “on-the-run treasury issues”
are discussed:

Method 1: Normal Method

• On-the-run treasury securities: These are the most recently auctioned issues of given maturity. These issues
include 3-month and 6-month Treasury bills, 2-year, 5-year, and 10-year Treasury notes and the 30-year
Treasury bond.

• Treasury bills are zero-coupon instruments and Treasury notes are coupon-paying instruments. Hence, there are
not many data points from which to construct a Treasury yield curve. That’s why, the 2-year, 5-year, and 10-
year Treasury notes and an estimate of the 30-year Treasury bond are used to construct the Treasury yield curve.
 মানে হন া, মানকে নট সকব ৬ মাে, ২ বছর, ৫ বছর, ১০ বছর ও ৩০ বছনরর সেজাপ্রর স্পট সরট এনভ্ইন ব । প্রকন্তু ১.৫ বছর, ৩ বছর, ৩.৫ বছর, ৪বছর, ৬
বছর ইতুাপ্রি সময়ানির সেজাপ্রর স্পট সরট মানকে নট এনভ্ইন ব ো। আর এইেব আে-এনভ্ইন ব সেজাপ্রর স্পট সরট সবর করার জেু এপ্রিপ্রস্টিং সেজাপ্রর স্পট
গুন া (৬ মাে, ২ বছর, ৫ বছর, ১০ বছর ও ৩০ বছনরর সেজাপ্রর স্পট সরট) ফময ে ায় বুবহার করা হয়।

• Now, the objective is to develop a theoretical spot rate curve with 60 semiannual spot rates (30 years er 60
semiannual spot rates). Excluding the 3-month bill, there are only 5 maturity points available (6-month, 2-year,
5-year, 10-year and 30-year) when only on-the-run issues are used. The 55 missing points are interpolated from
the surrounding maturity points on the par yield curve. The simplest and most commonly used interpolation
method is the linear extrapolation. On the basis of the yields at two maturity points on the par coupon curve,
the following is calculated:

(𝑦𝑖𝑒𝑙𝑑 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 – 𝑦𝑖𝑒𝑙𝑑 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦)

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡𝑤𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑝𝑜𝑖𝑛𝑡𝑠 + 1

• The yield for all intermediate semiannual maturity points is found by adding to the yield at the lower maturity
the amount computed from the formula. For example, the yields from the par coupon curve for the 2-year and
5-year on-the-run issues are 6% and 6.6% respectively. There are 5 semiannual time periods (2.5-year, 3-year,
3.5-year, 4-year, and 4.5-year) between the two maturity points. The extrapolated yield for these 5 semiannual
time periods is computed by first calculating:
(6.6% – 6%)
5+1
= 0.1%

Then,
Interpolated 2.5-year yield = 6.0% + 0.1% = 6.1%
Interpolated 3.0-year yield = 6.1% + 0.1% = 6.2%
Interpolated 3.5-year yield = 6.2% + 0.1% = 6.3%
Interpolated 4.0-year yield = 6.3% + 0.1% = 6.4%
Interpolated 5.5-year yield = 6.4% + 0.1% = 6.5%

• There are two problems with using only the on-the-run issues.
o First, there is a large gap between some of the maturity points which may result in misleading yields for
those maturity points, when estimated using the linear extrapolation method. The problem is more prevalent
in case of gap between 5 and 10-year maturity points and in case of 10 and 30-year maturity points.
o Second problem is that as the true yields are different from the quoted yields in the market, the yields of
the on-the-run issues themselves may be misleading.

Method 2: Bootstrapping Method

@ khata
5. Forward rate

Consider an investor who has a 1-year investment horizon and is faced with the following two alternatives:

(1) buy a 1-year Treasury bill, or

(2) buy a 6-month Treasury bill and, when it matures in six months, buy another 6-month Treasury bill

The investor will be indifferent toward the two alternatives if they produce the same return over the 1-year investment
horizon. The investor knows the spot rate on the 6-month Treasury bill and the 1-year Treasury bill. However, he does
not know what yield will be on a 6-month Treasury bill purchased six months from now. That is, he does not know the
6-month forward rate six months from now. Given the spot rates for the 6-month Treasury bill and the 1-year Treasury
bill, the forward rate on a 6-month Treasury bill is the rate that equalizes the dollar return between the two alternatives.

• To see how that rate can be determined, suppose that an investor purchased a 6-month Treasury bill for $X. At the
end of six months, the value of this investment would be:
Z1 = One-half of the theoretical 6-month spot rate

• If the investor were to rollover his investment by purchasing that bill at that time, then the future dollars available
at the end of one year from the X investment would be:
Let f represent one-half the forward rate on 6-month Treasury bill available six months
from now

• Now consider the alternative of investing in a 1-year Treasury bill. If we let Z2 represent one-half of the theoretical
1-year spot rate, then the future dollars available at the end of one year from the X investment would be:
The reason that the squared term appears is that 1 year includes 2 periods, each of 6
months. That means, semi-annual.

• The investor will be indifferent toward the two alternatives confronting him if he makes the same dollar investment
($X) and receives the same future dollars from both alternatives at the end of one year. That is, the investor will be
indifferent if:

Solving for f, we get:

Z1 = One-half of the theoretical 6-month spot rate
Z1 = One-half of the theoretical 1-year spot rate
f = One-half the forward rate on 6-month Treasury bill available six months from now

• The same line of reasoning can be used to obtain any forward rate beginning at any time period in the future. For
example:
o 6-month forward rate 3 years from now
o 2-years forward rate 5 years from now
o 3-years forward rate 4 years from now etc.

The formula used to determine such forward rate is:

1
(1+ 𝑧𝑚+1 ) 𝑚+1 𝑡 t = Number of time period rate
t f m=[
(1+ 𝑧𝑚 ) 𝑚 ] − 1 m = The period beginning m periods from now
For example, This is, 2-years forward rate 5 years from now. Where,

1
(1+ 𝑧10+4 ) 10+1 4 t = 4 (৬ মাে কনর, ২ বছনর সটাটা ৪টা প্রপপ্ররয়ি)
4 f 10 = [ ] −1
(1+ 𝑧10 ) 10 m = 10 (৬ মাে কনর, ৫ বছনর সটাটা ১০টা প্রপপ্ররয়ি)
[[NOTE: z10 মানে year-5 বরাবর spot rate সক 2 প্রিনয় (as semiannual) divide করন z10
পানবা ]]