Consider fixed-for-floating swaps with annual exchanges of cash flows and one-year LIBOR as the floating rate. The two-year swap rate and the three-year swap rate are 2% per annum and 2.2% per annum, respectively, both annually compounded. The risk- free zero interest rates are 1% for one year, 1.1% for two years, and 1.2% for three years, each continuously compounded. What is the forward LIBOR rate for the period between 2 years and 3 years? (Hint: Both 2-year and 3-year swaps have value zero so the differences in their cash flows also have value zero. You can assume the principal amount to be $100 million but it does not matter.)

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SOLUTION To determine the forward LIBOR rate for the period between 2 years and 3 years we need to use the concept of synthetic forward rate Lets begin by calculating the fixed rate for a twoyear swap ... View the full answer