ACCA Applied Skills · Financial Management · Causes of exchange rate differences and interest rate fluctuations
A 1-year zero-coupon government bond yields 4% and a 2-year zero-coupon bond yields 6%. Using the expectations theory, what is the implied one-year forward rate for the second year, to the nearest 0.01%?
The implied forward rate is 8.04%. Compound the 2-year spot rate, 1.06 squared equals 1.1236, then divide by the 1-year factor of 1.04, giving 1.0804. Simply doubling 6% and subtracting 4% ignores compounding.
- A8.00%
- B5.00%
- C8.04%Correct
- D6.00%
Explanation
(1.06)^2 = 1.1236. Divide by 1.04 = 1.08038, so the forward rate is 8.04%. The simple approximation 2×6% − 4% = 8.00% ignores compounding. Averaging gives 5%, which is the wrong method.
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