Could someone please explain the solution to this question as I am not getting it. As the spot rate is lower in the future are we not expecting the bond to be overvalued (discounted at a lower rate and so a higher number)
We are given bond Z. Maturing 3 years. Coupn 6%. Par = 1000
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You need to keep few things in mind:
Forward rates can be derived from the spot curve
Price of the bond is inversely related to spot/forward rates i.e. when rate is high, price is low
in this specific example, current forward rate (TODAY) is higher than what is projected from the spot curve. so a higher rate means a lower price today. so today the bond is undervalued and i would definitely purchase it.
Thanks Nic
What about the spot curve one year from today?
If it’s way above today’s forward curve, then it may well be that the bond today is overpriced.
In short, they’re missing essential information.
To confirm on this,
If the expected spot is greater then the forward then it is discounted at a higher number and thus has a lower PV then the forward. Therefore the forward relative to the spot is overvalued?
Does that mean in this case the forward is lik the market rate and the expected spot is our valuation?
Therefore the bond is over valued compared to our prediction? Or surely our bond (expected spot) is undervalued relative to the forward.
Sorry still a little unclear