Question

The interest rate on one-year to five-year bonds is 4%, 4.75%, 5.5%, 6.25%, 7% and the liquidity premiums for one-year to five-year bonds is 0%,0.25%,0.5%, 0.75%, 1%, what would be the one year forward rate (expected (forecasted) one-year interest rate one year in the future) and the four year forward rate?

Answer 1

One year interest rate at present is 4%

Suppose one year forward rate is i%

Then, (4+i)/2+liquidity premium for year 2 = 2 year interest rate

(4+i)/2+0.25=4.75

So, i=5

Thus, one year forward rate is 5% (Ans)

Now, using the same formula, (4+5+i2)/3+0.5=5.5

9+i2=15

So, two year forward rate is 6%

Now, using the same formula, (4+5+6+i3)/4+0.75=6.25

15+i3=22

So, three year forward rate is 7%

Now, using the same formula, (4+5+6+7+i4)/5+1=7

22+i4=30

So, four year forward rate is 8% (Ans)