Futures markets on short-term interest rates offer market participants a highly liquid, standardized alternative to FRAs. Interest rate futures contracts are available for monthly or quarterly market reference rates for successive periods out to final contract maturities of up to ten years in the future. Although the underlying variable is the market reference rate (MRR)…
Interest Rate Forward Contracts Spot Rates and Discount Factors Forward Rates
Pricing versus Valuation of Forward Contracts Pricing and Valuation of Forward Contracts at Initiation Pricing and Valuation of Forward Contracts with Additional Costs or Benefits
In the forward commitment example from the prior lesson, where no costs or benefits were associated with the underlying asset, the following relationship between the spot and forward prices was established: F0(T) = S0(1 + r)T. This relationship is shown under continuous compounding F0(T) = S0erT. The risk-free rate, r, denotes the opportunity cost of holding (“carrying”) the asset, whether or…
Replication is a strategy in which a derivative’s cash flow stream may be recreated using a combination of long or short positions in an underlying asset and borrowing or lending cash. In contrast to the earlier arbitrage examples, replication is typically used to mirror or offset a derivative position when the law of one price holds…
FVN = PV(1 + r)N where r is the stated interest rate per period and N is the number of compounding periods. Continuous compounding is the case in which the length of the uniform periods approaches zero, so the number of periods per year approaches infinity and is calculated using the natural logarithm, FVT = PVerT
