How to read forward yield questions

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rexthedog

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1Yr yield = 4%
2Yr yield = 5%
3Yr yield=6%
What is the rate for a one year loan beginning in one year?
The answer is 1.05^2/1.04 = 5%
I am not sure if I am misreading this question but if it is the one year loan beginning in one year would we not be looking at y3/y2? As this is to do with the loan BEGINNING In one year for ONE year?
Thanks
 
Also i noticed some answers for these types of questions show a square rooting of the yield answers and some do not. How do we know which to Square root and which not to?
 
Yes, the question means if 1 year from now you want to take out a 1 year loan, what would the interest rate be such that you would be indifferent between borrowing for two full years versus borrowing for 1 year and renewing that loan at that time.
For your second question, you would run into a root situation if the future loan ran over more than one year. For example, if you want the rate for a 2 year loan taken out 1 year from now, the answer would be (1.06^3/1.04)^(1/2).
 
rexthedog wrote:1Yr yield = 4%
2Yr yield = 5%
3Yr yield=6%
What is the rate for a one year loan beginning in one year?
The answer is 1.05^2/1.04 = 5%
Click to expand...
By the way, for whatever it’s worth,
1.05² / 1.04 − 1 ≈ 6%, not 5%.
 
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