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CMA Final · Strategic Financial Management · Interest Rate Derivatives

The annual-compounding zero-coupon spot yields in the market are 6% for one year and 7% for two years. What is the implied one-year forward rate, one year from now, to the nearest two decimals?

The implied one-year forward rate one year ahead is about 8.01%. It is found by dividing the two-year compounded factor 1.07 squared, or 1.1449, by the one-year factor 1.06, then subtracting one. Simple averaging or linear approximation gives incorrect figures.

  1. A8.00%
  2. B7.50%
  3. C7.01%
  4. D8.01%Correct

Explanation

The forward rate f satisfies (1.06)(1+f) = (1.07)^2. So 1+f = 1.1449/1.06 = 1.08009, giving f ≈ 8.01%. The 8.00% figure comes from the simple approximation 2×7% − 6%, and 7.50% is a plain average of the two rates, both of which ignore compounding.

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