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Good day tutor,
I am reading an article on INTEREST RATE FORWARDS (in detail for the first time) and got confused by the “in summary” section.
I’ll try to summarise everything below:
Annual spot yield curve:
Year 1: 3.5%
Year 2: 4.6%
Year 3: 5.4%Annual forward rates:
Year 2: 5.71%
Year 3: 7.02%In summary:
Supposing the company wants to borrow a sum of money for three years on the basis of the above rates:
i. it could pay annual interest at a rate of 5.40% in each of the three years, or
ii. it could pay interest at a rate 3.50% in the first year, 5.71% in the second year and 7.02% in the third year, or
iii. it could pay annual interest at a rate of 4.60% in each of the first two years and 7.02% in the third year.I am so confused with point i. If the company can pay interest at 5.4% for each of the 3 years, then why should it even consider point ii? The company would have to pay much higher interest rates in years 2 and 3 under point ii than it would have to under point i. Wouldn’t the spot yield rates change every year? I’m dying from this confusion
Why do you say that they would not even consider point (ii)??
OK – they will pay slightly more interest in the second year, and 1.62% more interest in the third year. But they will pay 1.9% less interest in the first year.
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