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ABC Pharmaceuticals' new rheumatoid arthritis drug recently passed phase III clinical trials. As the CFO, you...

ABC Pharmaceuticals' new rheumatoid arthritis drug recently passed phase III clinical trials. As the CFO, you plan to invest $100 million into a new drug launch in 2 years (after the FDA review process). To finance this project, you plan to borrow $100 million in 2 years for 1 year. You want to lock in an interest rate today. Suppose that the spot interest rates in the market today are as follows:

Maturity (years) Spot rate
1 1%
2 2%
3 3%

What is the fair interest rate (i.e., the forward rate) at which you can lock in your loan? (Note: Your answer should be a number in percentage form. Do not enter '%'.)

____%

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Answer #1

Spot Rates :

Year Spot Rates
r1 1%
r2 2%
r3 3%

Since Investment will be done in Year 02 for 01 Year i.e till Year 03

So effective interest rate from Year 02 to 03 2r3

Now using interest rate parity,

(1+r2) (1 + 2r3) = (1+r3)

(1+2r3) - - (1+ r3) (1+ r22

(1+2r3): - (1+0.03) (1+0.02)2

2r3 = 0.05233

2r3 = 5.23%

Ans : the forward rate  at which you can lock in your loan = 5.23%  

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