11. Using data in the following table, find the forward rates, assuming continuous compounding.

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A. x = 3.74%, y = 3.77%

B. x = 3.79%, y = 3.83%

C. x = 3.90%, y = 3.92%

D. x = 3.98%, y = 4.00%

Correct answer is Cfficeffice" />

Using continuous compounding, the forward rates are calculated as:

x = ln (e 0.0374 * 5 / e 0.037 * 4) / (5 ? 4) = 0.0374 * 5 ? 0.037 * 4 = 0.039

x = ln (e 0.0377 * 6 / e 0.0374 * 5) / (6 ? 5) = 0.0377 * 6 ? 0.0374 * 5 = 0.04

A is incorrect as it uses the same rates as zero rates for forward rates.

B is incorrect as it added 5 bp on top of the zero rates to derive forward rates.

C is correct.

D is incorrect.  It uses annual compounding instead of continuous compounding.

Reference: John Hull, Options, Futures, and Other Derivatives, 5th ed. (ffice:smarttags" />New York: Prentice Hall, 2003), Chapter 5.

Type of Question: Market Risk