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In the qs4 of pault Sept,/Dec 2016….how they are calculating forward rates ..is this interest rate cparity ..how is the formula used ..where does this -1 comes from ..in each year working of forward rates
No – it is not interest rate parity (it is based on a technical article on the ACCA website.
Suppose you invested $100 for 2 years using the yield curve rate of 4.25%.
It would grow to 100 x 1.0425^2Suppose instead you invested the $100 for 1 year at the one year rate (3.70%) and then for a further year at the 2 year forward rate of R.
The $100 would grow to 100 x (1.037) x (1+R).So….100 x 1.037 x (1+R) must be equal to 100 x 1.0425^2
Therefore 1.037 x (1+r) = 1.0425^2
1+r = 1.0425^2/1.037
R = (1.0425^2 / 1.037) – 1It is the same logic for the other rates.
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