FRM Part I · FRM Exam Part I · Pricing Conventions, Discounting, and Arbitrage
The discount factor is 0.9600 for 1 year and 0.9000 for 2 years. What is the annually compounded forward rate for the year running from t = 1 to t = 2?
The forward rate is 6.67%. The forward rate for year two is the ratio of the 1-year discount factor to the 2-year discount factor, minus one: 0.96 divided by 0.90 is 1.0667. Subtracting the discount factors directly gives the wrong 6.00%.
- A6.67%Correct
- B6.00%
- C6.25%
- D11.11%
Explanation
The forward rate is DF1/DF2 - 1 = 0.96/0.90 - 1 = 6.67%. The 6.00% option is the raw difference in discount factors, which uses the wrong base. The 11.11% option is the 2-year zero yield over the whole two years, 1/0.90 - 1.
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