CFA Level I · CFA Level I Exam · The Term Structure of Interest Rates: Spot, Par, and Forward Curves
Spot rates, annual compounding, are 2.00% for one year and 3.00% for two years. The discount factor for year 2 and the implied one-year forward rate one year from now are most likely:
The two-year discount factor is 0.9426 and the implied forward rate for one year starting in one year is 4.01%. The forward comes from 1.0609 divided by 1.02. Averaging the spot rates to get 2.50% is wrong.
- ADF 0.9426; forward 4.01%Correct
- BDF 0.9426; forward 2.50%
- CDF 0.9709; forward 4.01%
Explanation
DF2 = 1/1.03^2 = 0.9426. Forward = 1.03^2/1.02 − 1 = 1.0609/1.02 − 1 = 4.01%. The 2.50% is the simple average of the spot rates, which ignores compounding.
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