Spot, Forward, and Par Rates
It is clear from Chapter 1 that price and cash flows completely describe any fixed-rate investment. Nevertheless, investors and traders almost always find it more intuitive to express the time value of money in terms of interest rates. This chapter, therefore, introduces the most commonly-used interest rates, which are spot rates, forward rates, and par rates. The relationships linking these rates to discount factors and to each other reveal why interest rates are so intuitively appealing.
Given the importance of interest rate swaps as a benchmark of market interest rates, the illustrative examples and the trading case study of this chapter are taken from global swap markets. The valuation of interest rates swaps, however, is not covered by this book until Chapter 16. Until then, the reader is asked to accept the assertion, made here and justified there, that interest rates embedded in the swap market can be properly extracted by treating the fixed side of a swap as if it were a coupon bond and the floating side as if it were a floating rate bond worth par.1
The trading case study of this chapter begins by highlighting the abnormally downward-sloping forward rates of the EUR swap curve in the second quarter of 2010. Then, in the context of macroeconomic factors and market technicals, a trade is constructed to take advantage of this abnormally-shaped curve.
SIMPLE INTEREST AND COMPOUNDING
Price and cash flows completely describe an investment: ...