Assuming annual compounding, the prices of a one-year 4% coupon bond and a two-year 5% coupon bond are $101 and $99, respectively. The forward rate between one and two years is:
A) 4.5%
B) 5.0%
C) 6.8%
D) 8.3%

Question

Assuming annual compounding, the prices of a one-year 4% coupon bond and a two-year 5% coupon bond are $101 and $99, respectively. The forward rate between one and two years is: 
A) 4.5%
B) 5.0%
C) 6.8%
D) 8.3%

Quizplus · Accepted Answer

The forward rate can be calculated using the formula: (1 + 2-year rate)^2 / (1 + 1-year rate) - 1. First, find the yields: 1-year yield = 4% (since the bond price is $101 for a $100 face value bond), and the 2-year yield is approximately 5.5% (since the bond price is $99 for a $100 face value bond). Using these yields, the forward rate is approximately 8.3%.

Assuming Annual Compounding, the Prices of a One-Year 4% Coupon