CFAI curriculum page 236 (fixed income)
I don’t understand the solution provided in the books, can someone explain why the below 2 points are true? what formulae are these questions relating to also?
a bond will be overvalued if expected spot > current forward rate
a forward contract price will increase if future spot rates < current forward rates
If current forward rates are lower than expected future spot rates, the price of the bond is too high compared to what is expected (lower forward prices imply higher valuation of the bond). Remember that to value an option free bond, you use the 1 year forwards to calculate the binomial interest rate tree. If this rate is lower than expected future spot prices, the bond is overvalued.
If the current forward rates are higher than expected future spot prices, this means the bond is undervalued, hence you should go long on this. Most fixed-income investors react this way, hence, demand increases, and prices of forwards increase as well.