I have a question about Section 1.7 of Chapter 11. This compares the prices and rates for short term interest rate futures and forwards. Does anyone know whether the "forward rate" refers to a) the rate agreed at the start of the forward contract (ie R_k, continuously compounded, using the notation from Section 1.5) or b) the forward rate that applies in the market (ie R_f, continuously compounded)? Thanks
Here the forward and futures rates both refer to the current forward and futures rates, ie the rates we can agree now to borrow or lend over some future time period via either an FRA or an interest rate future. (The current forward rate being what we denoted by R(F) back in the FRA section). Of course, the rate agreed when an FRA is first entered into, ie R(K), is always equal to the forward rate at that time. It is the fact that the forward rate subsequently changes, so that the current forward rate [R(F)] differs from that originally agreed [R(K)], which results in the value of the FRA moving away from zero (which it was at outset).
So Rk is the fixed rate but we choose it to be equal to the current forward rate Rf so that the contract is initially zero? Then as time goes on the Rk stays at the same fixed rate and the new market spot rates give different Rf for the same forward period? So what happens when we get to the actual period that the exchange of interest is based on? Do we then settle up in cash or do I actually get my fixed interest payments? If a cash settlement, as we are now at the start of the payment period instead of a forward rate Rf do we use the current market spot rate to calculate the value? Thanks in advance
As I understand it we settle the contract for cash at maturity. And at this time the spot rate and forward rate would be equal, so it doesn't matter which we actually use to calculate the value.
