FRM Part I · FRM Exam Part I · Interest Rates
A 2-year zero rate is 5% per year continuously compounded and a 3-year zero rate is 5.5% per year continuously compounded. What is the forward rate for year 3, continuously compounded?
The year-3 forward rate is 6.5%. Total return to year 3 is 5.5% times 3, or 16.5%, and to year 2 is 10%; the difference of 6.5% earned over the final year is the forward rate.
- A5.50%
- B6.00%
- C6.50%Correct
- D7.00%
Explanation
Forward = (0.055*3 - 0.05*2)/1 = 0.165 - 0.10 = 6.5%. 6.00% would come from averaging incorrectly; 5.50% just repeats the 3-year rate.
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