I have read the CFAI definition forward rates and forwards spreads several times, but am pretty sure I don’t really understand them. It makes sense to me that the forward rates are indicative of the market’s expectations. What I don’t understand on a practical level is derivation from arbitrage arguments.
I guess what I am asking is how do actual practioners (I am not in FI) get the forward rates? Do you calculate it yourself or just get it off of Bloomberg or some other source. Are they estimates-so different sources could have different forwards?
Maybe I am thinking about this too hard. I am trying to understand the things I know I don’t really get.
Ok. I have the answer myself from consulting an FI friend. People don’t usually compute forward rates themselves, because you can get those quotes from Bloomberg. It is derived from the current curve (which doh! I should have understood) and therefore, it is not an estimate.
The arbitrage argument in math terms, also Level II stuff I should be remembering, is:
Example for 5 year bond
yields: 5yr=x, 2yr=y, 3yr=z
(1+x)^5=[(1+y)^2 x (1+z)^3]
The forward spread is also available as a quote on b-berg, but that’s just a matter of the derived forward rate (as above)-the foward rate of the benchmark (eg Treasury).
And if you are looking at 2 different issues on a relatve value basis, in practice you might use the current spread or the forward spread to rank them. It just depends on which you have a strong view on.
A response from the master is much appreciated. The article cleared the fog.
So your article is in the Level II section–that’s a good indication that I need to move on in my studying to spend more time on Level III test material.
And thanks very much for a link to your site. I will keep a keen eye out for more Level III articles.