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Dear Sir,
I have read the ACCA technical articles on the annual spot yield curve and I need a further help to understand it.In example 4 of the ACCA technical article “Bond valuation and bond yields”, in order to determine the yield curve, each bond C’s annual cash flows is discounted with a different discount rate e.g. 3.88% for year one, 4.96% for year two and 5.80% for year three)
However, according to the example in the article “Determining interest rate forwards and their application to swap valuation” the interest rate quoted by the bank based on the annual spot yield curve is not different each year, but the same for both years for a two year bond e.g. it is 4.6% in year one and 4.6% in year two.
Could you possibly clarify?
Thank you.I think I understand your confusion.
The yield curve is showing the ‘overall’ interest per annum for different time periods, whereas the forward rates are the interest for each individual year.
So, for example, if the first years interest is (say) 5% and the second years forward rate is (say) 8%, then the ‘average’ rate of interest per year over the 2 years is going to be somewhere between 5% and 8%.
If we know the forward rates then we can calculate the ‘average’ rate per year (and this is what would appear in the yield curve. Alternatively, if we know the ‘average’ rate per year and we know the rate for the first year, we can then calculate the forward rate for the second year.
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