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FRM Part II · FRM Exam Part II · Expectations, Risk Premium, Convexity and the Shape of the Term Structure

Spot rates (annually compounded) are 2.00% for one year, 3.00% for two years and 3.50% for three years. What is the implied one-year forward rate two years from now, closest to?

The implied forward rate from year two to year three is about 4.51%. It equals the three-year growth factor of 1.035 cubed divided by the two-year factor of 1.03 squared, minus one, which is approximately 4.508%.

  1. A4.51%Correct
  2. B5.00%
  3. C3.50%
  4. D4.00%

Explanation

Forward = 1.035^3 / 1.03^2 - 1 = 1.108718 / 1.0609 - 1 = 4.508%, about 4.51%. The 5.00% option uses a simple 3x3.5 - 2x3 = 4.5... error-prone linear approximation mix; 3.50% just repeats the three-year spot.

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