For some odd reason, calculating forward rates, is the one concept in L1 , i cant get my head around. mental block or something. Any samaritans, care to help, if not on here, possibly msn. I could really use some help. thanks in anticipation.
zigga - have you got a specific question in mind maybe? i was the same, but after doing a couple questions it starts to become intuitive…
Ziggazaa, One useful way to understand the intuition of forward rates is forget the mathematics for a second and place yourself in the shoes of your average person on the street. Suppose you have $100 you want to invest (because you won your office pool by betting against the Patriots who end up losing the Super Bowl). You have a choice between two alternative investment schemes. The first is you invest your $100 in Investment F1 for four years after which the investment matures. At that point you decided you want to defer consumption for another two years. In other words you decided not to spend the money and reinvest for another two years, say, in Investment F2. So your money is tied up for a total of 4 + 2 = 6 years. The second is you make your life simple by simply buying a six year investment in Investment S with your $100. If markets are in equilibrium, you should be no better of doing the first as opposed to doing the second investment (and vice versa). The forward rate comes into play under the first investment scheme at the end of the four years. You wonder, “What rate should I ask for in Investment F2 if I am going to have my money tied up for another two years?” Well, it had better be a rate that will leave you with as much money at the end of year 6 as if you had just invested your money six years straight (under Investment S). That rate during years 5 and 6 is the two-year forward rate (four years from today). The idea here is that the theory will mean more if you understand the real life problem the theory is designed to address. Not to make things needlessly confusing, but forward rates are constructed from an underlying sequence of spot rates (which themselves are constructed from an underlying sequence of benchmark rates). It is very easy, I find, to confuse spot rates with forward rates. As with forward rates, if you can get at the real life situation that the theory of spot rates is designed to address, then there should be no confusion between forward and spot rates. Hope this helps.