Chapter 3: Spot Rates, Forward Rates and the Term Structure

The annuity formulas in Chapter 2 are derived based on the assumption that the rates of interest are constant through time and do not vary with the periods of the payments due. In practice, however, we would expect interest rates to change over time. Furthermore, the rates of interest may vary according to the time to maturity (the due date) of the payments. In this chapter we introduce the spot rate of interest and discuss the relationship between the rates of interest and the time to maturity, called the term structure of interest rates. We also define the notion of the forward rate of interest, and describe the relationship between the spot and forward rates of interest…