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FRM Part I · FRM Exam Part I · Properties of Interest Rates

Annually compounded zero rates are 4.0% for 1 year and 5.0% for 2 years. What is the implied one-year forward rate, annually compounded, from year 1 to year 2?

The implied forward rate is about 6.01%. With annual compounding, the 2-year growth factor of 1.1025 divided by the 1-year factor of 1.04 gives 1.0601. Averaging the zero rates would understate the forward rate because the 2-year rate covers both years.

  1. A6.01%Correct
  2. B5.50%
  3. C4.50%
  4. D6.25%

Explanation

(1.05)^2 = 1.1025 and 1.1025/1.04 = 1.06010, so the forward rate is 6.01%. The 4.50% option is the simple average of the two rates. The 5.50% option adds the rate difference to the 2-year rate with the wrong scaling and does not match the compounding relationship.

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