Consider spot rates for three zero-coupon bonds: r(1) = 3%, r(2) = 4%, and r(3)

Question

Consider spot rates for three zero-coupon bonds: r(1) = 3%, r(2) = 4%, and r(3) = 5%. Which statement below is correct? The forward rate for a one-year loan beginning in one year will be:

Less than the forward rate for a one-year loan beginning in two years.

Greater than the forward rate for a two-year loan beginning in two years.

Greater than the forward rate for a one-year loan beginning in two years.

Less than the forward rate for a one-year loan beginning in two years.

Greater than the forward rate for a two-year loan beginning in two years.

Greater than the forward rate for a one-year loan beginning in two years.

Explanation / Answer

We need to calc forward rate for one year beginning in one year

= (1 + spot rate at year2)^2 / (1 + spot rate at year1)^1 - 1

= 5%

forward rate for one year beginning in two years

= (1 + spot rate at year3)^3 / (1 + spot rate at year2)^2 - 1

= 7%

Here we can see that option A is correct

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