Question

The current 2-year spot rate is 4% and current 5-year spot rate is 5.5%. According to the pure expectation theory of the term structure of interest rates, what is the forward rate for 1-year securities beginning three years from today?

A)        6.44%

B)        7.79%

C)        8.23%

D)        9.58%

Answer 1

We are given,

2 yr spot rate = 4%

5 yr spot rate = 5.5%

forward rate for 1-year securities beginning three years from today = ?

We can calculate it by the following formula,

Forward rate for 1 yr security beg. 3 yrs from today = (( 1 + 5.50%)^5 / (1 + 4%)^2)^1/3 - 1

Forward rate for 1 yr security beg. 3 yrs from today = (1.30696 / 1.0816 )^1/3 -1 = 6.44%

Hence, the forward rate for 1-year securities beginning 3 years from today is 6.44%

The answer is option a) 6.44%.

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