Can anyone please help me understand & make a rational or think of consistent formula that I can use to convert between spot & forward rates. I thought I mastered the calculations, then bumped into this question and couldn’t solve it!
An investor wants to take advantage of the 5-year spot rate, currently at a level of 4.0%. Unfortunately, the investor just invested all of his funds in a 2-year bond with a yield of 3.2%. The investor contacts his broker, who tells him that in two years he can purchase a 3-year bond and end up with the same return currently offered on the 5-year bond. What 3-year forward rate beginning two years from now will allow the investor to earn a return equivalent to the 5-year spot rate? Answer is 4.5%
For this type of problem, you want to equate the ending amount of a 5 year buy and hold with 2 year investment and reinvest for a further 3 years (assuming bond equivalent yields):
Baidar - I look at the calculation like the below. It helped me early on w synthetic FRA and Spot/Forward problems to draw things out…IE draw a line for the full spot (5 Year) and then a line below broken into the known (2 year bond) and the unkonwn (3 year @ x rate).