I am getting confused on how to remember time periods for the different types of question, as in, when we need to make it to the power of, and when we need to multiply by. E.g Forward price (to the power of) = spot * [(1+r) ^ T]
FRA interest savings (multiply by) = [market interest rate x T/360] - [contract interest rate x T/360] x notional
Unannualise an interest rate (multiply by) = 1 + (rate x (days/360))
Interest rate derivative instrument (multiply by) = principal x (index - cap rate) x (actual / 360) Can someone please explain this so i understand it and won’t get confused.
It’s simply a matter of knowing whether you’re using an effective rate (for which you compound, as in your first example) or a nominal rate (for which you do not compound, as in your other three examples).
On the exam, they’ll have to tell you whether the rate is effective or nominal. You are expected to know, however, that LIBOR is nominal; they won’t tell you that.
many questions though do not tell you whether the rate is effective or nominal, e.g.: - consider a 3 month forward contract, face $1,000, currently quoted at $500, risk-free annual interest rate of 6%. Determine price of forward contract. - assume 1x4 FRA, notional $1,000,000, at contract expiration 90 day rate has increased to 6%, which is above contract rate of 5.32%. Calculate value of FRA at maturity. So how can we know when they don’t mention explicitly?
by doing enough problems
by reading CFAI book and seeing what is the convention followed there
a problem and solution dealt with in one way - does not suddenly change.
And if you did read the CFAI book - I can guarantee you that there are a host of oft-repeated phrases, examples strewn throughout - and they are all dealing with / stating what their position is.
So from the curriculum most problems deal with a nominal rate. The exception are forwards and futures (not including FRAs which use LIBOR) which deal with an effective interest rate. Is that correct?
The forwards in Econ use nominal rates.
Just to throw you, I’m sure.
okay, well if we’re doing an econ question, i’ll just have to remember it is a nominal rate, as opposed to forwards/futures outside of econ.