For years 2€“5, compute the following:
a. The forward interest rate, rf, for a forward rate agreement that settles at the time borrowing is repaid. That is, if you borrow at t ˆ’ 1 at the 1-year rate Ëœr, and repay the loan at t, the contract payoff in year t is
(Ëœr ˆ’ rf)
b. The forward interest rate, re, for a Eurodollar-style forward rate agreement that settles at the time borrowing is initiated. That is, if you borrow at t €“ 1 at the 1-year rate Ëœr, and repay the loan at t, the contract payoff in year t ˆ’ 1 is
(Ëœr ˆ’ re)
c. How is the difference between rf and re affected by volatility (you can compare the two trees) and time to maturity?
For the next four problems, here are two BDT interest rate trees with effective annual interest rates at each node.

Transcribed Image Text:

Tree #1 0.08000 0.07676 0.08170 0.07943 0.07552 0.10362 0.10635 0.09953 0.09084 0.13843 0.12473 0.10927 0.15630 0.13143 0.15809 Tree #2 0.08000 0.08112 0.08749 0.0826 0.07284 0.09908 0.10689 0.10096 0.08907 0.13060 0.12338 0.10891 0.15078 0.13317 0.16283