Given the yield on a 3 year zero-coupon bond is 7% and forward rates of 6% in year 1 and 6.5% in year 2,what must be the forward rate in year 3?
A)7.2%
B)8.6%
C)8.5%
D)6.9%
E)none of the above.

Question

Quizplus · Accepted Answer

To solve the problem, we can use the formula of calculating forward rate:

(1+ f3)^3 = (1+ r3) * (1+ f1)^1 * (1+ f2)^2

where f1 and f2 are the given forward rates, and r3 is the unknown forward rate in year 3.

Plugging in the values, we get:

(1+ r3)^3 = (1+ 7%) * (1+ 6%) * (1+ 6.5%)
(1+ r3)^3 = 1.07 * 1.06 * 1.065
(1+ r3)^3 = 1.2034

Taking cube root on both sides, we get:

1 + r3 = 1.085
r3 = 0.085 = 8.5%

Therefore, the answer is (C) 8.5%.

Given the Yield on a 3 Year Zero-Coupon Bond Is