FI 4000

Zero Coupon Bond Forward Contract

Are Forward Rates Good For Anything?

Suppose you can contract today for delivery of a one period zero coupon bond

one period hence. This is like the T-Bill future. For simplicity we express terms as a

percent of par value of the zero coupon bonds.

Let z1 denote the one period spot rate and let z2 denote the two period spot rate.

We claim that the forward price F0 must satisfy

100
F0 = , (*)
1  1 f1

100
where f is the one period forward rate one period hence. For suppose F0 < .
1 1
1  1 f1

Then buy the bond forward and short a two period zero coupon bond now. Invest the

proceeds of the short sale in one period zero coupon bonds. Explicitly, purchase

1  1  1 f1  of the one period zero. The cash flows are as follows.

Cash Flows Now One Period

Buy Forward 0 - F0 + bond

Sell Short P2 cover short using bond bought forward

P1 100
Invest Proceeds -
1  1 f1 1  1 f1

100
Net 0 - F0
1  1 f1
 100 100 P1
The net now is 0 because P2 = =
 1  z2 
2
 1  z1   1  1 f1  1  1 f1 , by the definition of
=

100
the spot rates and the forward rate. The net in one period of - F0 is by assumption
1  1 f1

positive and is therefore arbitrage profit.

100
Similarly, if F0 > , then sell forward and purchase a two period zero coupon
1  1 f1

P1
bond by borrowing (shorting 1  1  1 f1  of the one period bonds) . The cash flows
1  1 f1

are as follows.

Cash Flows Now One Period

Sell Forward 0 F0 - bond

Buy - P2 deliver bond on forward contract

P1 100
Short Sell -
1  1 f1 1  1 f1

100
Net 0 F0 -
1  1 f1

100 100 P1
Again, the net now is 0 because P2 = =
 1  z2 
2
 1  z1   1  1 f1  1  1 f1 . There is
=

100
arbitrage profit of F0 - > 0 (by assumption) in one period.
1  1 f1
So, in the absence of arbitrage, (*) must hold. The implications of (*) are that

Buying forward a zero coupon bond is tantamount to contracting now to lend at

the rate 1 f1 for one period, one period from now. You pay F0 in one period and

you receive a one period zero coupon bond that pays F0  1  1 f1  one period from

then.

Selling forward a zero coupon bond is tantamount to contracting now to borrow at

the rate 1 f1 for one period, one period from now. In one period, you receive F0

and you must borrow a one period zero coupon bond to deliver on the forward

sale. In one period, you owe the lender of the borrowed bond F0  1  1 f1  .

More generally, consider a forward contract for a one period zero coupon bond to

be delivered in t periods. Then by the same argument used above, but with spot positions

in a zero coupon bond with t + 1 periods to maturity, to avoid arbitrage, the forward price

must be given by the equation

100
F0 =
 1  t f1  . (**)
So, in the absence of arbitrage, (**) must hold. The implications of (**) are that

Buying forward a one period zero coupon bond in t periods is tantamount to

contracting now to lend at the rate t f1 for one period, t periods from now. You

pay F0 in t periods and you receive a one period zero coupon bond that pays you

F0  1  t f1  one period from then.

Selling forward a one period zero coupon bond in t periods is tantamount to

contracting now to borrow at the rate t f1 for one period, t periods from now. In t

periods, you receive F0 and you must borrow a one period zero coupon bond to

deliver on the forward sale. In one period, you owe the lender of the borrowed

bond F0  1  t f1  .

You can actually create these forward positions synthetically using put and call options

on Treasury bills. See the handout notes “Synthetic Treasury Bill Forward Contracts.”