Worked solution · Exam FM
This Exam FM sample reference tests Forward Interest Rate. Indifference requires the five-year spot accumulation to equal three years at 5.75% followed by two years at the forward loan rate. Solving gives 9.53999%, choice D.
Independent solution
Setup
The 6000 principal cancels when the two five-year repayment amounts are equated.
Model
Isolate the two-year forward accumulation factor.
Compute
Take the positive square root and subtract one.
Answer
The two-year loan must charge 9.54% annually, choice D.
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Error diagnosis
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Original practice · fully worked
The annual effective spot rate is 4% for a two-year investment and 6% for a five-year investment. Determine the constant annual effective forward rate applying over years 3 through 5.
Equating five-year accumulation to two years at 4% followed by three forward years gives a forward rate of 7.3547%, choice C.
Setup
Let f be the annual forward rate for the three years after time 2.
Model
Solve for the forward accumulation factor.
Compute
The result is 1.07354655.
Answer
The three-year forward rate is 7.35%, choice C.
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