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FRM Part I · FRM Exam Part I · Bond Yields and Return Calculations

A 1-year zero-coupon bond yields 5% and a 2-year zero yields 4%, both annually compounded. What does this inverted curve imply about the 1-year forward rate one year ahead?

The implied forward rate is about 3.01%, below both spot rates. It is 1.04 squared divided by 1.05, minus one. In an inverted curve, forward rates fall below the spot rates because the longer-term spot rate is lower than the short-term rate.

  1. AIt is above 5%
  2. BIt equals 4%
  3. CIt is below 4%, about 3.01%Correct
  4. DIt is negative

Explanation

Forward = 1.04^2/1.05 - 1 = 1.0816/1.05 - 1 = 3.01%. When the spot curve is downward sloping, forward rates lie below the spot rates. It is not negative, and it does not equal the 2-year spot rate.

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