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CFA Level I · CFA Level I Exam · The Term Structure of Interest Rates: Spot, Par, and Forward Curves

The one-year spot rate is 3.00% and the two-year spot rate is 4.00%, both annual-pay. The one-year forward rate one year from now, 1y1y, is closest to:

The 1y1y forward rate is about 5.01%. Divide the two-year growth factor of 1.04 squared, 1.0816, by the one-year factor of 1.03 to get 1.0501. Averaging the spot rates to get 3.50% is wrong.

  1. A3.50%
  2. B4.00%
  3. C5.01%Correct

Explanation

(1.04)^2 = 1.0816. Dividing by 1.03 gives 1.05010, so the forward rate is 5.01%. The 3.50% option is the simple average of the two spot rates, which ignores compounding and is wrong.

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