CFA Practice Question

CFA Practice Question

The price of a 5 year maturity Zero of face value $1 is $0.80. The price of a 6 year maturity Zero of face value $1 is $0.75. The Forward Rate from the 5th to the 6th year is:
A. 6.82%
B. 6.93%
C. 6.67%
Explanation: The Forward Rate is the rate of return that we can 'lock in' today for an investment that we will make from the 5th to the 6th year (one-year investment). An alternative way to do this is to sell a 5 year Zero today to receive $0.94. Use this money to buy $0.80/$0.75 = 1.06667 units of the 6 year Zero. Cash flow today = 0; Cash flow 5 years from now = -$1 (as short the 5 year Zero); Cash flow 6 years from now = $1.06667. Hence return = 6.667%. As 'alternative way' has the same results as entering into a Forward, therefore by Absence of Arbitrage the Forward Rate must be 6.667%

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