Working out Forward Rates

Given that no one knows which way the rates are going to move in the future, how do banks and those who work with forward rates actually calculate what figures to give for them?

Well, it is not just a total guess, though some might say if the markets were predictable in any way at all then people would always be able to cash in.

What the banks do is actually to arbitrage with regard to lending of money - if they lend money for two years at a spot rate today, then they should think it the same to lend someone a year from now the money for a year at that spot rate, and so on.

And so this is the principle of how it all works - just looking at the rates they are happy to use today, how long they will be extended for, and therefore allowing people to come in at those rates for a certain time period in the future.

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