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Locking a Future Two-Year Investment Rate with a Forward Rate Agreement

Article Quant Q&A · Author: Alex T.
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Summary

The question considers how to invest a large sum that will arrive at the end of year two and remain invested for two years. It provides continuously compounded zero-coupon yields across maturities and asks which approach offers the safest real-term investment, comparing a forward loan, a four-year loan, and waiting to invest when the money arrives.

The response identifies a forward rate agreement as the way to lock the future interest rate. This addresses uncertainty about rates available at the time the funds arrive, while the supplied yield curve allows the implied forward rate to be derived. The excerpt does not show the calculation or clarify precisely what “safest in real terms” means; an FRA locks a nominal rate, and inflation exposure or counterparty and instrument details are not discussed.

Key ideas

  • A future cash inflow can be matched to a forward loan covering the period when it will be invested.
  • The yield curve can be used to infer the forward rate for that future period.
  • A forward rate agreement locks the rate and avoids relying on rates available at the future investment date.
  • The cited answer does not provide the numerical forward-rate calculation or address inflation risk.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# Zero-coupon Loan Investment


# Zero-coupon Loan Investment












Zero-coupon default-free interest rates maturing over the next five years are listed below (in percent per annum, continuously-compounded):

Maturity Years -- Yield

1 --------------------1.9

2 --------------------2.2

3 --------------------2.5

4 --------------------2.8

5 --------------------3.4

You expect to inherit $50 million at the end of year two, and would like to invest it for two additional years in the safest possible instrument in real terms. What is the safest investment and its rate of return?

a) Execute a forward loan at 3.4%

b) Lend for four years at 2.8%

c) Execute a forward loan at 3.7%

d) Wait two years and lend for two years

I think I know what to do when the interest rate is constant but I'm not sure what to do when it changes like this. Since the 50$ million inflow is coming in at the end of year 2, do I start looking at the table from year 3?

Any help appreciated!

## Answer by Srinivasan J (score 1)

https://quant.stackexchange.com/a/30781

Safest would be FRA to lock the interest rates.

Thanks

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.