CFA Level I · CFA Level I Exam · The Term Structure of Interest Rates: Spot, Par, and Forward Curves
The one-year spot rate is 2.00% and the two-year spot rate is 3.00%, both annual-pay. The one-year forward rate one year from now is closest to:
The forward rate is about 4.01%. The two-year growth factor of 1.03 squared equals 1.0609, and dividing by the one-year factor of 1.02 gives 1.0401. The simple average of 2.50% ignores compounding and understates the forward rate.
- A2.50%
- B3.50%
- C4.01%Correct
Explanation
(1.03)^2 = 1.0609. Dividing by 1.02 gives 1.040098, so the forward rate is 4.01%. The 3.50% option wrongly adds the spot rates and halves them in a different way, and 2.50% is a simple average.
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