7.5 Pricing and Valuation of Forward Contracts and for an Underlying with Varying maturities

Question 1

the zero rate

Answer 1

The spot rate for period T

it can be thought of the yield on a zero-coupon bond with a maturity of T

Question 2

Spot rates are important inputs in the valuation of interest rate forward contracts because

Answer 2

these instruments are priced based on the yield for a single cash flow to be received at a future date.

Question 3

implied forward rate (IFR)

Answer 3

the rate that is required to ensure that the following strategies produce the same return:

Investing at the B-year spot rate.

Investing at the spot rate for A years and then reinvesting the proceeds at the IFR for the period from A to B.

Question 4

forward rate agreements (FRAs)

Answer 4

Forward contracts on interest rates

The over-the-counter agreements are essentially interest rate swaps that only have one settlement rather than a series of periodic settlements

In practice, FRAs are almost exclusively used by financial intermediaries to manage the interest rate exposure of their assets and liabilities.

A forward rate agreement is initiated at time 0 with a fixed rate for a loan that begins at time A and settles at time B.

–> This forward rate specified in this agreement is set ensure that the contract has no net value to either party at initiation

The FRA buyer (i.e., the long party) agrees to pay the fixed rate and receive the prevailing MRR for the period from A to B

The payoff is calculated as the product of the contract’s notional value and the difference between the fixed rate and the prevailing MRR