E Interest represented by “r3” is_
A. spot rate on a three-year investment (APR)
B. spot rate on a two-year investment (APR)
C. expected spot rate 2 years from today
D. expected spot rate one year from today
The Correct Answer and Explanation is:
The correct answer is:
C) Expected spot rate 2 years from today
Explanation:
The notation “r3” typically represents an interest rate associated with a specific time horizon. To determine what “r3” refers to in the given options, it’s essential to understand the fundamental concepts of interest rates, spot rates, and forward rates.
Understanding Spot Rates and Forward Rates
- A spot rate is the interest rate applicable to an investment made today that matures at a future date.
- A forward rate is the expected future interest rate for a specific period, derived from current spot rates.
Interpreting “r3” in the Context of the Term Structure of Interest Rates
- The notation r3 is often used in yield curve analysis and bond pricing to denote the expected spot rate at a future time, specifically for a given term.
- However, when analyzing future interest rates, we use the forward rate concept, which allows us to determine the expected interest rate for a future period.
- In this case, r3 refers to the expected spot rate two years from today, meaning it represents the market’s expectation of the interest rate that will prevail at that time.
Eliminating Incorrect Options
- Option A (Spot rate on a three-year investment APR): Incorrect. The spot rate for a three-year investment would be denoted as S3, not r3.
- Option B (Spot rate on a two-year investment APR): Incorrect. The spot rate for a two-year investment is S2, not r3.
- Option D (Expected spot rate one year from today): Incorrect. The expected spot rate one year from today would typically be r2, not r3.
Thus, the correct answer is Option C: “Expected spot rate two years from today.”
