You want to decide whether to invest in zero-coupon bonds or not. Currently, the yield to maturity of these zero-coupon bonds for the one-year is 8% and for the two-year is 9%. Given this information what is the forward rate of interest for the second year?

a. 10.01%

b. 8%

c. 9.2%

d. 3.25%

The forward rate of interest for the second year is;

a. 10.01%

Explanation:

Step 1: Determine the 1 year final value of the investment

The formula for calculating the final value for the 1 year investment is;

F. V=P. V (1+r)

where;

F. V=final value

P. V=present value

r=yield to maturity

In our case;

F. V=unknown

P. V=x

r=8%=8/100=0.08

replacing;

F. V=x (1+0.08) = 1.08 x

Step 2: Determine the 2 year final value of the investment

Using the formula;

F. V=P. V (1+r) ²

where;

F. V=unknown

P. V=x

r=9%=9/100=0.09

replacing;

F. V=x (1+0.09) ²=1.1881 x

Step 3: Determine the forward rate of interest for the second year

The forward rate of interest can be expressed as;

forward rate of interest = (2-year future value/1-year future value) - 1

replacing;

forward rate of interest = (1.1881 x/1.08 x) - 1=0.10009*100=10.01%

forward rate of interest=10.01%