CMA Final · Strategic Financial Management · Interest Rate Derivatives
The 1-year zero-coupon spot rate is 6% p.a. and the 2-year zero-coupon spot rate is 7% p.a., both annually compounded. Assuming no arbitrage, what is the implied 1-year forward rate starting one year from now?
The implied one-year forward rate one year ahead is about 8.01%. Compounding for two years at 7% gives 1.1449; dividing by the one-year growth factor of 1.06 leaves 1.0801. The shortcut of 8.00% ignores compounding.
- A8.01%Correct
- B8.00%
- C7.50%
- D7.01%
Explanation
Forward rate = (1.07^2 / 1.06) - 1 = 1.1449 / 1.06 - 1 = 1.08009 - 1 = 8.01%. Using 2 x 7% - 6% = 8.00% is a simple-interest shortcut that ignores compounding. The 7.5% option is the simple average of the spot rates.
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