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%

Question

Quizplus · Accepted Answer

The yield of a zero-coupon bond is related to its spot rates and forward rates. For a 3-year zero-coupon bond with a yield of 7%, the compounded return over 3 years equals (1 + 7%)^3. The forward rates for years 1 and 2 are given as 6% and 6.5%, respectively. To find the forward rate for year 3, we can use the formula that equates the compounded return of the bond to the product of the 1-year spot rate, the 1-year forward rate for year 2, and the 1-year forward rate for year 3. Mathematically, this is represented as (1 + 0.07)^3 = (1 + 0.06) * (1 + 0.065) * (1 + f3), where f3 is the forward rate for year 3. Solving for f3 gives us approximately 8.5%.

Given the Yield on a 3-Year Zero-Coupon Bond Is 7