The current structure spot rates is the following: 1-year 3.25% 2-year 3.5% 3-ye

Question

The current structure spot rates is the following: 1-year 3.25% 2-year 3.5% 3-year 3.9% 4-year 4.2% 5-year 4.25% Required 1. Your first task is to fix the cost of financing (the interest rate) for a 3-year borrowing starting in 1 year from now. Using the structure of the spot rates presented above, compute this rate. 2. Your CEO is not happy with this 3-year borrowing in one piece. He wants to speculate on a fall interest rates in the future and therefore he prefers you to borrow for 1-year periods and rollover. Thus, compute the three consecutive 1-year borrowing rates that you expect to receive, starting in 1 year from now. 3. One year later, your CEO is very preoccupied. Taking 3 times 1 year borrowing was not a good idea. So far, the structure of spot rates has not changed at all. Then, the CEO asks you to quickly

Explanation / Answer

1) cost of 3 year borrowing starting one year from now is same as 4 year borrowing now and short the borrowing for the first year. Thus the effective borrowing cost is ( 4 * 4.2 - 3.25 )/ 3 = 4.517% 2)in the first year,i.e 1 year from now you expect to receive at 3.5 * 2 - 3.25 = 3.75%, the next year its 3.9 * 3 - 3.5 * 2 = 4.7%, and the 3rd year the interest rate is 4.2 * 4 - 3.9 * 3 = 5.1 % 3)the rate would be the 3year rate i.e 3.9%.

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