CMA Final · Strategic Financial Management · Interest Rate Derivatives
In the market, the 1-year zero-coupon spot rate is 6% p.a. and the 2-year zero-coupon spot rate is 7% p.a. (annual compounding). What is the implied 1-year forward rate starting one year from now?
The implied one-year forward rate one year ahead is 8.01%. It is found by dividing the two-year compounded growth factor (1.07 squared) by the one-year growth factor (1.06) and subtracting one, rather than averaging the two spot rates.
- A6.50%
- B7.50%
- C8.01%Correct
- D9.00%
Explanation
Forward rate f satisfies (1.06)(1+f) = (1.07)^2. So 1+f = 1.1449/1.06 = 1.0801, giving f = 8.01%. The 6.50% option simply averages the two spot rates, which ignores compounding and the fact that the second year must earn more to lift the 2-year yield.
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