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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

The 1-year spot rate is 3.0% and the 2-year spot rate is 4.0% (annual compounding). What is the implied 1-year forward rate starting in one year, to the nearest 0.01%?

The implied one-year forward rate one year ahead is 5.01%. Compute 1.04 squared, which is 1.0816, divide by 1.03 to get 1.0501, and subtract one. The simple 5.00% shortcut ignores compounding.

  1. A5.01%Correct
  2. B5.00%
  3. C3.50%
  4. D4.00%

Explanation

(1.04)^2 = 1.0816. Dividing by 1.03 gives 1.05010, so the forward rate is 5.01%. The 5.00% option is the simple 2x4% - 3% shortcut, which ignores compounding. The 3.50% option is the simple average of the two rates, and 4.00% is just the 2-year spot rate.

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