Note on a Theoretical Justification for Approximations of Arithmetic Forwards

Abstract

This brief note explores the theoretical justification for some approximations of arithmetic forwards ($F_a$) with weighted averages of overnight (ON) forwards ($F_k$). The central equation presented in this analysis is: \begin{equation*} F_a(0;T_s,T_e)=\frac{1}{\tau(T_s,T_e)}\sum_{k=1}^K \tau_k \mathcal{A}_k F_k\,, \end{equation*} with $\mathcal{A}_k$ being explicit model-dependent quantities that, under certain market scenarios, are close to one. We will present computationally cheaper methods that approximate $F_a$, i.e., we will define some $\{\tilde{\mathcal{A}}_k\}_{k=1}^K$ such that \begin{equation*} F_a(0;T_s,T_e)\approx \frac{1}{\tau(T_s,T_e)}\sum_{k=1}^K \tilde{\mathcal{A}}_k \tau_k F_k\,. \end{equation*} We also demonstrate that one of these forms can be closely aligned with an approximation suggested by Katsumi Takada in his work on the valuation of arithmetic averages of Fed Funds rates.