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CFA Level I · CFA Level I Exam · The Term Structure of Interest Rates: Spot, Par, and Forward Curves

An analyst observes that the one-year spot rate is 3.00% and the two-year spot rate is 4.00%, both annual-pay. The implied one-year forward rate one year from now is closest to:

The implied one-year forward rate one year from now is about 5.01%. It is found by dividing the two-year compounded growth factor of 1.0816 by the one-year factor of 1.03, then subtracting one. Simple averaging gives the wrong figure because it ignores compounding.

  1. A3.50%
  2. B5.01%Correct
  3. C5.50%

Explanation

(1.04)^2 = (1.03)(1+f), so 1+f = 1.0816/1.03 = 1.05010, so f = 5.01%. The simple average of 3.50% ignores compounding, and 5.50% is wrong because it adds the spread to the two-year rate.

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