Forward Rate Meaning Example Calculation Vs Spot Rate

Forward Rate Meaning

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This rate, also known as forward yield, allows investors to choose from various investment options, such as US Treasury BillsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more (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 curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. read more. It is commonly used for hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more and serves as a financial marketFinancial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more economic indicator.

Forward Rate Explained

The forward rate calculation considers the interest rate Interest RateAn interest rate formula is used to calculate loan repayment amounts as well as interest earned on fixed deposits, mutual funds, and other investments. It is also used to calculate credit card interest.read more observed for the investment that has reached maturityMaturityMaturity value is the amount to be received on the due date or on the maturity of instrument/security that the investor holds over time. It is calculated by multiplying the principal amount to the compounding interest, further calculated by one plus rate of interest to the period’s power.read more 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 bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more or other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more only when they find forward yields worthy of those investments.

Key Takeaways

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.

It involves a Forward Rate AgreementForward Rate AgreementForward Rate Agreement or FRA is a contract between two entities wherein interest rate is fixed for the future. The purpose of such contracts is hedging against the fluctuating interest rates. read more (FRA), a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more 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.

Formula

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 TaTa = Maturity period for one termRb = Spot rate for the bond with maturity period TbTb = Maturity period for the second term

Calculation

Forward rates can be calculated using the spot rateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more or yield curve. The latter depicts the association between the rates of interest observed for government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income.read more 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 bondTreasury BondA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more.

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 reinvestingReinvestingReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more 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.

Example

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 valueFuture ValueThe Future Value (FV) formula is a financial terminology used to calculate cash flow value at a futuristic date compared to the original receipt. The objective of the FV equation is to determine the future value of a prospective investment and whether the returns yield sufficient returns to factor in the time value of money.read more 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%

Forward Rate vs Spot Rate

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 marketCurrency MarketFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more is key in speculating the forward yield.

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