Definition and Example of Forward Rate
How Forward Rate Works
What Forward Rates Mean for Individual Investors
Forward Rate vs. Current Exchange Rate
Disadvantages of Forward Rate
Definition and Example of Forward Rate
Forward rate is the interest rate that will be paid on a loan or investment made in the future. It is called forward rate because it occurs “forward in time”.
How Forward Rate Works
Forward rates are used to estimate the interest rate you could earn on a bond or other securities you might consider purchasing in the future. You can calculate the forward rate using the yield curve (for government bonds of different maturities) or the spot rate (for zero-coupon bonds).
The general formula for forward rate looks like this:
fn = [(1+rn)n / (1+rn-1)n-1] – 1
Where:
fn = forward rate over the second year
rn = spot rate for n years
rn-1 = spot rate for n – 1 years
For example, let’s assume you want to invest in bonds. After shopping around, you identify two options:
A one-year zero-coupon bond yielding a return of 9%
A two-year zero-coupon bond yielding a return of 10%
You want to know what the forward rate for the first year in the second year of the two-year bond is. So you use this equation to calculate it:
[(1.10)2 / (1.09)1] – 1
1.21 / 1.09 = 1.11 or 11%
Thus, by investing in the two-year zero-coupon bond, you are essentially securing a forward return rate of 11% for the second year.
Securing a forward rate on a loan or currency deal can be beneficial if you are concerned about fluctuations in interest rates in the future.
What Forward Rates Mean for Individual Investors
Forward rates on currency deals are primarily used by corporations. Let’s say you own a large company that has relationships with a supplier in Canada. You have a bill of $500,000 coming due in six months, and you know you will need to convert a large amount of currency. You have two options:
You can wait one year and execute the transaction at the current exchange rate (this would be a spot transaction). You can secure the terms of the transaction today using a futures contract (known as hedging).
If you fear that exchange rates will be less favorable in the future, you can secure a forward rate with a bank to help mitigate risk and protect your profit margins.
Forward Rate vs. Current Exchange Rate
Forward rate is always mentioned in discussions about the current exchange rate. The main difference is that the forward rate applies to transactions that will occur in the future, while the current exchange rate applies to transactions that happen now (usually within two business days).
The other main difference is that current exchange rates fluctuate with the market, so they are subject to change at any time. While future rates are predetermined, so you know what the prices will be in the future.
Disadvantages of Forward Rate
Although forward rate can be useful in managing interest rate risks, it is important to keep in mind that it is not without limitations.
First and foremost, forward rate is merely an estimate. It becomes less reliable the longer the time frame you are estimating into the future. So it can be good if you are trying to estimate rates for a few months or a year, but then the accuracy of the forward rate starts to decline.
Source: https://www.thebalancemoney.com/what-is-a-forward-rate-5221538
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