1
00:00:00,440 --> 00:00:01,493
[CROSSTALK]

2
00:00:01,493 --> 00:00:02,078
[NOISE]

3
00:00:02,078 --> 00:00:06,056
Can you explain the difference between a

4
00:00:06,056 --> 00:00:11,022
Forward, forward and a forward rate
agreement?

5
00:00:11,022 --> 00:00:11,487
[SOUND]

6
00:00:11,487 --> 00:00:15,858
A forward, forward and a forward rate
agreement, and a

7
00:00:15,858 --> 00:00:20,060
FRA, and I suppose we could call a forward
also.

8
00:00:23,086 --> 00:00:28,320
The whol,this whole lecture, where I'm
talking about, for,

9
00:00:28,320 --> 00:00:32,360
forward rates and the expectations
hypothesis and all of that.

10
00:00:32,360 --> 00:00:33,290
Okay.

11
00:00:33,290 --> 00:00:36,790
The point of this lecture is to begin to
build

12
00:00:36,790 --> 00:00:39,940
some intuition that we're going to use
later on about derivatives.

13
00:00:39,940 --> 00:00:48,802
So, the for, forward interest parity.
Calling it forward

14
00:00:48,802 --> 00:00:54,842
Interest Parity is

15
00:00:56,050 --> 00:01:02,694
I write it, 1 plus R 0 N,

16
00:01:02,694 --> 00:01:04,204
[SOUND]

17
00:01:04,204 --> 00:01:09,036
times 1 plus F N T,

18
00:01:09,036 --> 00:01:14,774
equals 1 plus R(0,

19
00:01:14,774 --> 00:01:20,850
T).
Right?

20
00:01:20,850 --> 00:01:21,250
Yes.

21
00:01:21,250 --> 00:01:24,518
Okay, and the the point of this is to say,
this

22
00:01:24,518 --> 00:01:27,406
is a, this is a an interest rate, this is
eh,

23
00:01:27,406 --> 00:01:27,938
[UNKNOWN]

24
00:01:27,938 --> 00:01:32,069
that you can observe today okay, between
time zero and time N.

25
00:01:32,069 --> 00:01:34,289
This is an interest rate that you can

26
00:01:34,289 --> 00:01:37,060
observe today between time zero and time
T.

27
00:01:37,060 --> 00:01:37,870
Okay.

28
00:01:37,870 --> 00:01:42,375
And the point of the, the deep point
behind all this, is that if

29
00:01:42,375 --> 00:01:47,395
you can borrow and lend at this rate, and
borrow and lend at this rate.

30
00:01:47,395 --> 00:01:50,149
Now, of course there's going to be a bit
as

31
00:01:50,149 --> 00:01:53,146
spread in there, but this came before we
did

32
00:01:53,146 --> 00:01:57,480
market making, so let's just abstract from
bit as spreads.

33
00:01:57,480 --> 00:02:00,550
So let's just think that you can borrow or
lend at this rate.

34
00:02:00,550 --> 00:02:00,550
>>

35
00:02:00,550 --> 00:02:00,910
[COUGH]

36
00:02:00,910 --> 00:02:03,520
>> And you could borrow or lend at this
rate.

37
00:02:03,520 --> 00:02:06,820
The point is that you can construct, okay,
with

38
00:02:06,820 --> 00:02:11,400
these fundamental assets a, a forward a
forward rate.

39
00:02:11,400 --> 00:02:14,676
You can, you ca, can construct the ability
to

40
00:02:14,676 --> 00:02:17,870
borrow at time N and pay back at time T.

41
00:02:17,870 --> 00:02:18,050
Okay.

42
00:02:18,050 --> 00:02:26,200
And the way you would do that is, if you
were a bank, okay, okay,

43
00:02:26,200 --> 00:02:33,090
you want to, if you had borrowing 1 plus R
0 no, borrowing.

44
00:02:34,620 --> 00:02:35,880
Put it on the other side.

45
00:02:35,880 --> 00:02:38,260
1 plus R 0 T.

46
00:02:38,260 --> 00:02:43,590
So if you're borrowing for at, at, at, for
this ti, this amount of time, and you're

47
00:02:43,590 --> 00:02:49,190
lending for this amount of time, okay,
essentially what

48
00:02:49,190 --> 00:02:51,270
you're doing is you're expanding your
balance sheet on

49
00:02:51,270 --> 00:02:53,860
both sides today, you're neither borrowing
nor lending.

50
00:02:53,860 --> 00:02:55,010
Nothing's happening.

51
00:02:55,010 --> 00:02:55,950
Okay?

52
00:02:55,950 --> 00:03:01,200
you understand this notation?
I'm saying this is, this is, this is a,

53
00:03:01,200 --> 00:03:10,338
term, T borrowing, okay?
And this is term N lending.

54
00:03:10,338 --> 00:03:12,900
[SOUND].

55
00:03:12,900 --> 00:03:16,870
Yeah, sometimes I make up weird notation
that confuses people.

56
00:03:16,870 --> 00:03:19,080
So, so let me just be clear what that is.

57
00:03:19,080 --> 00:03:23,830
And so you're, eh, eh, at time zero,
you're neither borrowing nor lending.

58
00:03:23,830 --> 00:03:31,590
Okay, but at time, N, okay, suddenly,
this, you, you get money.

59
00:03:31,590 --> 00:03:34,510
Okay, that's what this, you know, this
thing, this thing matures.

60
00:03:34,510 --> 00:03:35,250
Okay.

61
00:03:35,250 --> 00:03:38,750
And at time, T, you have to pay money,
okay.

62
00:03:38,750 --> 00:03:39,600
Well what is that?

63
00:03:39,600 --> 00:03:42,080
You get money at time N, you pay it at
time T.

64
00:03:42,080 --> 00:03:45,810
That's like borrowing it at time, at time
N, and paying back at time T.

65
00:03:45,810 --> 00:03:50,450
So, you're creating a synthetic future
loan, basically.

66
00:03:50,450 --> 00:03:52,240
By, by doing this long and short
positions.

67
00:03:52,240 --> 00:03:52,240
>>

68
00:03:52,240 --> 00:03:52,656
[COUGH]

69
00:03:52,656 --> 00:03:53,156
>> Okay.

70
00:03:54,270 --> 00:03:56,570
And that is essentially borrowing at this
rate.

71
00:03:57,780 --> 00:03:58,230
Okay?

72
00:03:58,230 --> 00:04:00,300
This is the rate, the forward rate is the

73
00:04:00,300 --> 00:04:04,040
rate you can lock in today using these
existing instruments.

74
00:04:05,550 --> 00:04:07,828
Okay, and that's what forward interest
parity says.

75
00:04:07,828 --> 00:04:11,660
Forward interest parity says that if you
are trading, if you are just

76
00:04:11,660 --> 00:04:15,670
trading with people in the forward market,
okay, this is the forward rate.

77
00:04:15,670 --> 00:04:17,670
The forward rate has to be this.
It cannot be

78
00:04:17,670 --> 00:04:20,200
anything other than this because you could
roll

79
00:04:20,200 --> 00:04:22,910
your own forward rate, okay, in these
markets.

80
00:04:22,910 --> 00:04:23,990
[SOUND]

81
00:04:23,990 --> 00:04:29,375
Okay, that's the basic idea.
Then, I think

82
00:04:29,375 --> 00:04:29,740
[UNKNOWN]

83
00:04:29,740 --> 00:04:31,170
it was, it was you that asked this
question.

84
00:04:31,170 --> 00:04:35,010
Okay, so now you, you asked these specific
questions about all these other things.

85
00:04:35,010 --> 00:04:37,195
All these other things are in that
lecture.

86
00:04:37,195 --> 00:04:37,585
[LAUGH]

87
00:04:37,585 --> 00:04:41,329
To, to as, as examples, historical
examples

88
00:04:41,329 --> 00:04:44,420
that are in, that are in, in stigham.

89
00:04:44,420 --> 00:04:49,840
About how the banking system, created
different, it, it

90
00:04:49,840 --> 00:04:53,390
doesn't want to have, it doesn't want to
use these synthetic structures.

91
00:04:53,390 --> 00:04:56,040
Okay, because it takes up balance sheet
space.

92
00:04:56,040 --> 00:04:59,130
You know, if you had, if your balance
sheet is expanding on both

93
00:04:59,130 --> 00:05:02,590
sides and you're not lending or borrowing,
you're not making any money and

94
00:05:02,590 --> 00:05:07,600
you have fixed capital and you have fixed
reserves, okay.

95
00:05:09,780 --> 00:05:13,170
And it looks like you're, you know, you're
taking risk.

96
00:05:13,170 --> 00:05:16,190
and, and liquidity risk and solvency risk
and

97
00:05:16,190 --> 00:05:18,230
all of this and the regulators aren't
going to

98
00:05:18,230 --> 00:05:19,670
like that, your board of governors aren't
going to

99
00:05:19,670 --> 00:05:21,650
like that, no one's going to like that,
okay?

100
00:05:21,650 --> 00:05:28,120
So, and, so the, the attempt is to create
instruments that have this effect that are

101
00:05:28,120 --> 00:05:29,940
just a if they, you are borrowing and

102
00:05:29,940 --> 00:05:32,660
lending but there is various levels of
netting out.

103
00:05:32,660 --> 00:05:35,340
Okay, that are, that are happening and

104
00:05:35,340 --> 00:05:41,310
the our forward agreement nets everything
out of, of, of but you actually you agree

105
00:05:41,310 --> 00:05:45,500
to do this thing you know our forward
agreement says in three months,okay?

106
00:05:45,500 --> 00:05:49,650
I will lend you so much money and at such,
such a rate, okay.

107
00:05:49,650 --> 00:05:54,110
A FRA is just a, is just a side bet on
what, for rate agreement,

108
00:05:54,110 --> 00:05:59,300
is a side bet on what the interest rate
will be three, three, months from now.

109
00:05:59,300 --> 00:06:00,450
Okay, so it's a sort

110
00:06:00,450 --> 00:06:02,650
of derivative contract.

111
00:06:02,650 --> 00:06:07,418
and a forward, forward, forward, forward
was what?

112
00:06:07,418 --> 00:06:10,985
forward, forward is, I think, I think this
was

113
00:06:10,985 --> 00:06:11,594
[UNKNOWN]

114
00:06:11,594 --> 00:06:15,596
forward, forward was in agreement was an
agreement,

115
00:06:15,596 --> 00:06:19,100
to, I forgot what a forward, forward is.

116
00:06:19,100 --> 00:06:22,100
>> When the net principal payments are

117
00:06:22,100 --> 00:06:24,000
on the balance sheet, they're not zeroed
out.

118
00:06:24,000 --> 00:06:24,140
>> Okay.

119
00:06:24,140 --> 00:06:26,589
There, there, but the point is all the
three of these.

120
00:06:26,589 --> 00:06:28,439
Are, are different versions of, of this,

121
00:06:28,439 --> 00:06:30,689
where you're, where you're netting out
principal

122
00:06:30,689 --> 00:06:34,700
payments or you're not, or you're netting
out the interest payments or you're not.

123
00:06:34,700 --> 00:06:36,570
But the underlying,

124
00:06:36,570 --> 00:06:40,990
the underlying conceptual basis of it is
all this.

125
00:06:40,990 --> 00:06:43,740
All of them are the, are doing the same
thing.

126
00:06:43,740 --> 00:06:45,720
In different, in different ways.

127
00:06:45,720 --> 00:06:47,960
You can see all this very clearly.

128
00:06:47,960 --> 00:06:50,035
This, the reason I go to this effort,
okay,

129
00:06:50,035 --> 00:06:50,360
[LAUGH],

130
00:06:50,360 --> 00:06:52,960
is that you can see all this very clearly
when you're dealing

131
00:06:52,960 --> 00:06:55,920
with fixed income instruments and the
money market and all of this.

132
00:06:55,920 --> 00:06:58,620
When you start to move into foreign
exchange, when you

133
00:06:58,620 --> 00:07:03,070
start to move into credit default swaps,
we lose our intuition.

134
00:07:03,070 --> 00:07:06,690
Okay, but, but it's the same intuition as
this.

135
00:07:06,690 --> 00:07:11,690
So once we, if we really consolidate that,
we're going to be happier

136
00:07:11,690 --> 00:07:14,970
after the midterm is the, is the idea, is
the idea here.