Spot - Forward Rate Question

CFA Level I
#1

I am confussed as to how to think through when to take the square root or 1/2 degree of the formula? I assume it is because we are getting the 2 year rate and need to account for compounding? Something isn’t clicking for me with this problem and I was hopoing someone could walk me through the logic? I greatly appreciate any help!

The following interest rate information is observed:

Spot Rates 1 year 10% 2 years 11% 3 years 12%

Based on this data, the 2-year forward rate one year from now is closest to:

A - 12%

B - 13%

C - 14%

Solution:

#2

Your thinking is correct: the square root accounts for the fact that money is invested for 2 full years at time 1. The 2 year forward rate 1 year from now should be such that if I invest money for 1 year at 10%, then for 2 years at the calculated forward rate, I should end up with exactly the same future value as if I invested for 3 full years at 12% at time 0. A little algebraic shuffling gets you to the solution as presented.

#3

Thank you for the response!!!

So at first calculation, the 2 year forward rate is not annualized and is the entire 2 year holding period return?

I think that is what I was missing… Once you have the 2 year forward rate, you need to annualize it?

Does that make sense?

#4

That’s correct.

I wrote an article on this that may be of some help: http://financialexamhelp123.com/calculating-forward-rates-from-spot-rates/.

#5

Thanks for the help and your website is very helpful!

#6

My pleasure.

I’m glad that it is.