Here is the question from a practice test sch 1 yr 10% 2 yr 11% 3 yr 12% Above are spot rates What is the 2 yr forward rate one year from now is closest to ? How are earth do u do this?
spot rate yr 3 plu 1 ^3/spot rate yr 2 plus 1^2… 13.82%… anyone know that averaging trick??? you should learn that if possible. i somewhat know it
Easy way to visualize it is to draw out a timeline and put the spot rates where they need to go, then fill in the missing part that you are trying to solve. Then just use the geo. mean to solve for the answer.
in order to avoid obvious arbitrage buying 3-year bond should should produce the same cash flows as buying any number of bonds in between so you say (1.12)^3 = (1.10)*(1+1fr2)^2 the first element is the spot rate for a 3-year bond the first element on the RHS is buying a bond for 1 year the second element is the 2yr forward rate 1 year from now if you think about it, you are saying buying a bond at the 3-year spot rate, is the same as buying a bond at the 1-year spot rate then a bond at the 2-year forward rate 1 year from now sqrt [1.12^3 / 1.1] = 13.01%
I actually don’t think you’re correct. I believe it should be [(1.12^3)/(1.10)]^.5 What you wrote would be the one year forward rate 2 years from now… not the 2 year forward rate one year from now, right?
1.12 ^3 ----------- 1.11^2 is this not correct?
mcf Wrote: ------------------------------------------------------- > I actually don’t think you’re correct. > > I believe it should be > > [(1.12^3)/(1.10)]^.5 > > What you wrote would be the one year forward rate > 2 years from now… not the 2 year forward rate one > year from now, right? ahhhhh
The answer sch gives is just 13.01%
I guess I dont understand why u are raising the 1 yr spot to .5
you’re trying to find the geometric average of the 2-year return
The question in book says 2 yr for 1 yr from now
You have to raise the calc to the .5 in order to get the geometric average for 1 year.
i should stop typing out these really long posts explaining everything in detail because i don’t think anyone reads them but i guess it’s good practice for me
You feel that was too sometimes Sharp? Ha!
so whats correct now?
What both Sharp and I previously posted.
But if you were doing a 1 yr forward rate 2 yrs from now, you would do ex. (1.12)^3/(1.08)^2, and we wouldnt have divide the ^2 by 2 like we did above
Where are you pulling out the 8% value?! Also, if you are doing a two year forward rate, the exponent in the numerator HAS TO BE 2 larger than the exponent in the denominator.
is 1f2 the 1 year forward rate 2 years from now or the 2 year forward rate 1 year from now?
ryanwtyler Wrote: ------------------------------------------------------- > is 1f2 the 1 year forward rate 2 years from now or > the 2 year forward rate 1 year from now? good questions. i’m all confused now.