Chartered Financial Analyst (CFA) Practice Exam Level 2

How are forward rates defined?

1. They are current spot rates

2. They are the rates that have not yet occurred

3. They are the rates expected for future spot rates

4. They are determined by bond maturities

The correct answer is: They are the rates expected for future spot rates

Forward rates are defined as the rates that are expected for future spot rates. They represent the market's expectations of future interest rates and are derived from the current spot rates of various maturities. Essentially, forward rates provide insight into what the market anticipates will happen to interest rates over a specified time period in the future. This concept is particularly significant in the context of the yield curve, as forward rates can be calculated from existing spot rates, allowing investors to make informed predictions about future rate changes. They are crucial in both fixed-income securities and interest rate derivatives, influencing how investors price various financial instruments and make strategic investment decisions. Other definitions, such as the notion that forward rates are current spot rates, would misrepresent their nature as future rates rather than present ones. Likewise, stating that they are rates that have not yet occurred is too vague and does not capture the essence of their derived nature based on current information. The definition relating them to bond maturities alone also misses the specific focus on expectations of future conditions, which is key to understanding forward rates.