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    Spot Rates and Forward Rate

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    Given the following spot rates for various periods of time from today, calculate forward rates from years one to two, two to three, and three to four.

    Years from today spot rate
    1 10.0%
    2 5.5%
    3 6.5%
    4 7.0%

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    Solution Preview

    The forward rates must be such that the returns of two equivalent investments are equal.

    Let's start with the forward rate from year 1 to 2.

    These are two equivalent investments:
    1) Invest $1 today for 2 years, at the 2-year annual rate of 5.5%. The return from this investment, with annual compounding, will clearly be (1+0.055)^2
    2) Invest $1 today for 1 year, at the 1-year annual rate of 10%. One year ...

    Solution Summary

    The expert examines spot rates and forward rates.