Hey guys, I was having trouble understanding this, wonder if one of you could explain it to me. In book 4, one of the questions (pretend its January) asks for the yeild on a 2-year bond for Jan 09’ (using coupon interest). However in the Note it says “it is a 2-year bond but 1-year from now so the investment horizon is 3 years.” So you would use Jan, 11 rates? Can someone explain the reasoning behind this. Thanks.
You are looking for the 2 year forward rate 1 year from now. That is an unbiased estimator of the 2 year spot rate in Jan '09.
So I would use the Jan, 11 rates in my formula if they are given?
(1+Jan '11 Spot rate)^3 = (1 + Jan 09 Spot Rate) * (1 + 2yr FWD rate 1 year from now)^2 That’s how you solve for the 2 yr FWD rate 1 yr from now, when the two spot rates are given.
This condition has to hold to prevent arbitrage.
or it holds because of arbitrage…