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Application Concept: Forward Interest Rates

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Textbook ELI8 Relatable Practical Use

The Scene: Netflix Subscription Magic 

You're a die-hard fan of a popular streaming service and decide to secure your entertainment future. Your favorite series is locked in for the next two years, and you want to know what the future cost of your subscription might be.

Step 1: The Spot Rates Spell 

  1. Discovering Spot Rates:

    • Imagine each year of your subscription as a bond with a different maturity. Spot rates are like the magic numbers representing the cost of each yearly installment.

    • Spot Rate (Year 1): The cost of the first-year subscription is $10/month, so the spot rate for the first year is 10%.

    • Spot Rate (Year 2): For the second year, the cost jumps to $12/month, making the spot rate 12%.

Step 2: Casting the Forward Rate Spell 

  1. Predicting the Future:

    • You're curious about the cost of the third year, so you use the spot rates to calculate the one-year forward rate for the third year.

    • Formula for Forward Rate:

      • Forward Rate = [(1 + Spot Rate (n + k))^n / (1 + Spot Rate (n))]^(1/k) - 1

    • Forward Rate (Year 3):

      • Plug in the values: [(1 + 0.12)^3 / (1 + 0.10)]^(1/2) - 1
      • Calculate, and voila! The forward rate for the third year is approximately 11.86%.

Step 3: The Subscription Crystal Ball 

  1. Peering into the Future:
    • You've glimpsed the future! The calculated forward rate suggests that in the third year, the subscription cost might increase by around 11.86%.

Benefits & Drawbacks: The Magical Insight 

Benefits:

  • Superpower of Prediction: Armed with forward rates, you can anticipate changes in subscription costs, allowing you to budget wisely.
  • Cash Flow Insight: Knowing the expected cost helps plan your entertainment expenses ahead.

Drawbacks:

  • Market Surprises: Remember, forward rates rely on market expectations, and unexpected events might disrupt the predicted rates.

Conclusion: Your Financial Wizardry Unleashed! 

In this magical tale, forward rates become your financial crystal ball, predicting the future cost of your streaming subscription. With this newfound wizardry, you're ready to navigate the ever-changing landscape of subscription prices! 

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.