Fixed Income Investments  Forward Rates vs Spot Rates
Let's say an investor buys a twoyear zerocoupon bond. The proceeds will equal:
X (1 + z_{6})^{6}.
The investor could also buy a sixmonth Treasury bill and reinvest the proceeds every six months for two years. In this case, the value would be:
X (1 + z_{1})(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3) (1 + future rate at time 4)
Because these two investments must be equal this tells us that:
X (1 + z_{6})^{6 }= X (1 + z_{1})(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3)
So Z_{6} = [(1 + z_{1})(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3)]^{Â¼}  1
This equation states that the twoyear spot rate depends on the current sixmonth rate and the following three sixmonth spot rates.
As we can see, shortterm forward rates must equal spot rates or else an arbitrage opportunity can exist in the market place.
Compute Spot Rates if Given Forward Rates, and Forward Rates if Given Spot Rates
Computing a forward rate by using spot rates is covered above. Using spot rates, an investor can develop any forward rate.
There are two elements to the forward rate. The first is when the future rate begins. The second is the length of time for that rate. The notation is length of time of the forward rate f when the forward rate began. For example, a 2 f 8 would be the 1year (two sixmonth periods) forward rate beginning four years (eight sixmonth periods) from now.
To solve for tFm use the following equation:
Formula 15.13
tFm =[ (1 + Z_{m}_{+t})^{m+t} / (1 + Z_{m})^{m}] ^{1/t}  1 
So for a 3f5 it would equal an equation of: [(1 + z_{8})^{8}/ (1 + z_{5})^{5}]^{1/3 }1
Example:
Z_{3}(the 1.5 year spot rate) = 3.5%/2 = .0175
Z_{5} (the 2.5 year spot rate) = 4.25%/2 = .02125
Answer:
So 3f5 =[(1.02125)/ (1.0175)^{5}]^{1/3} 1
S3f5 = .027916
Doubling this rate gives you a rate of 5.58%
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