ACCA Applied Skills · Financial Management · The valuation of debt and other financial assets
Under the pure expectations theory, the current 1-year spot yield is 4% and the current 2-year spot yield is 5%. What is the implied 1-year forward rate starting in one year, to two decimal places?
The implied one-year forward rate in one year is 6.01%. Compound the two-year spot rate to 1.05 squared, which is 1.1025, then divide by the one-year growth factor of 1.04. This gives 1.0601, so the forward rate is 6.01%.
- A6.00%
- B5.50%
- C6.01%Correct
- D4.50%
Explanation
(1.05)^2 = 1.1025. Divide by 1.04 = 1.06010, so the forward rate is 6.01%. The 6.00% option is the simple approximation 2×5%−4%, ignoring compounding. The 5.50% option wrongly averages the two rates... and 4.50% is the simple average of 4 and 5.
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