Question

interest on 1 year and 2 year treasuries are currently 5.6 and 6.0% respectively. what is the 1 year rate from now? (forward rate)

Answer 1

The basic relation between forward rate and spot rate for two periods is following –

(1+S2)^2 = (1+ S1) * (1+1Y1Y)

Or (1+S2) ^2 / (1+ S1) = (1+1Y1Y)

Where,

S1 is 1 year spot interest on treasury = 5.6%

S2 is 2 years spot interest on treasury = 6.0%

And 1Y1Y is one year forward rate after one year from today =?

Therefore,

(1+1Y1Y) = (1 +6%) ^2 / (1+ 5.6%)

Or (1+1Y1Y) = 1.0640

Or 1Y1Y = 1.0640 -1 = 0.0640 or 6.40%

Therefore one year forward rate after one year from today is 6.40%