What is forward rate model?

Hey guys, it's William Jiamin here. In this video, I'm going to share with you a forward rate model. As the name suggests, the forward rate model is a model for forward rates.

Imagine a time frame of M and N. If you're an investor and you buy a bond, holding it from time zero all the way to time N, and if you're an investor who buys a bond, holds it from time zero to time M, and then sells it to reinvest in another bond starting at time M and ending at time N, the forward rate model states that these two investment strategies are equivalent. The investor is indifferent between these two strategies, whether they invest multiple times or just once from time zero to time N.

The essence of the forward rate model lies in the fact that if we use spot rates, denoted as 1 + S, raised to the power of M + N, this represents the investment return when investing 1 unit at time zero and holding it until time N. Similarly, if we use the forward rate starting at time M and add N, raised to the power of N, this represents the investment return when investing 1 unit for a certain period, selling it, and reinvesting using the forward rate. The key idea is that these two investments should yield the same result.

So, the forward rate model allows us to compare the returns from holding a bond for the entire period versus investing for a certain period and then reinvesting. The final result should be the same, showing that the model holds true.

That's the forward rate model for you. I hope that clarifies it. If you have any questions, feel free to ask.