Forward Rate

The forward rate refers to the expected yield or interest rate on a future bond or forex investment or even loans/debts. It requires investors to sign a contract agreeing to carry out a financial transaction at a specific future date. Hence, its calculation typically involves interest rate and maturity period.

This rate, also known as forward yield, allows investors to choose from various investment options, such as US Treasury Bills (T-bills), depending on predicted interest rates. Two typical ways to estimate the future yield on an investment are the spot rate and the yield curve. It is commonly used for hedging and serves as a financial market economic indicator.

• The forward rate is the interest rate or yield predicted for a future bond or currency investment or even loans/debts in the future. Besides the interest rate, maturity time is another component of its calculation.
• It allows investors to choose from multiple investment options, such as US Treasury Bills (T-bills), using the spot rate and the yield curve.
• It is frequently used for hedging and is seen as an economic indicator that aids investors in reducing currency market risks.
• The difference between forward yield and spot rate is that the latter represents the current interest rate or yield for bonds that must be settled and delivered on the same day. 

The forward rate calculation considers the interest rate observed for the investment that has reached maturity lately. Based on this analysis or projection, traders decide if a future yield for the investment is profitable. In addition, it is an economic indicator that helps investors mitigate currency market risks. As a result, investors prefer investing in bonds or other financial instruments only when they find forward yields worthy of those investments.

It involves a Forward Rate Agreement (FRA), a derivative contract between two parties who agree to complete the transaction later. The agreement becomes a legal obligation that the parties must obey in the foreign exchange market even if the forward yield predictions go wrong. Forward yield also helps determine the future value of bonds. The future date can range from a few months to a year.

Even though FRAs sound similar to futures contracts, there is a significant distinction between the two. While currency forwards can be customized to meet the individual needs of the parties involved in the transaction, futures cannot be tailored and have predetermined contract size and expiration dates.

The standard formula used for forward rate calculation is:

Forward Rate = ((1+Ra)^Ta/(1+Rb)^Tb  - 1)

Where,

• Ra = Spot rate for the bond with maturity period Ta
• Ta = Maturity period for one term
• Rb = Spot rate for the bond with maturity period Tb
• Tb = Maturity period for the second term

Forward rates can be calculated using the spot rate or yield curve. The latter depicts the association between the rates of interest observed for government bonds of various maturities. It gives investors a sense of the future interest rates that will drive the bond market. As a result, they predict the forward yield and make investment decisions based on that forecast. On the other hand, the former is the yield assumed on a zero-coupon Treasury bond.

Suppose an investor wishes to buy a one-year bond. The two alternatives available are acquiring a 1-year T-bill or investing in a six-month T-bill and reinvesting it for the next six months. Here, the investor will know the spot rate for six-month or 1-year at the start of the investment. However, the forward yield, whose exact amount is unknown, is the interest rate the investor speculates on purchasing the second six-month T-bill.

Let us consider the following forward rate example to understand its calculation:

Suppose Megan buys a five-year bond with an annual yield of 8% and a three-year bond with an annual yield of 6%. She uses the forward rate formula to estimate the future value and decide whether to invest in it or not.

Forward Rate = ((1+Ra)^Ta/(1+Rb)^Tb  - 1) = ((1+0.08)⁵/(1+0.06)³  - 1)

                       = 0.233692695

                       = 23.37%

Given below is a forward rate chart taken from TradingView. The chart depicts the rate two years from now, and this can be used as the future rates for a specific financial instrument to ensure risk control against interest fluctuations. In this manner, the method benefits not only investors but also exporters, who can decide the future exchange rate now for their export orders to be undertaken in the future and prevent any loss due to a rise in the rate when the actual delivery takes place.

Source

The forward yield is the interest rate paid on a bond in the future. On the other hand, the spot rate is the interest rate for future contracts that must be settled and delivered immediately (on the spot) or on the same day. Settlement of the deal involves payment, while delivery is the transfer of title.

Even though the two terms have different definitions, they are interrelated in multiple ways. The spot rate of investments is essential to calculate the forward yield. The rate of interest that drives the currency market is key in speculating the forward yield.

The differences between the forward rate and spot rate are as follows:

This has been a guide to Forward Rate & its Meaning. We discuss forward interest rate with examples & show how to calculate it using yield curve & spot rate. You can learn more about financing from the following articles -

• Fixed Rate Bonds
• Interest Rate Parity
• Forward Price