Forward Rate

Forward Rate

A forward rate is an interest rate applicable to a financial transaction that will take place in the future. Forward rates are calculated from the spot rate and are adjusted for the cost of carry to determine the future interest rate that equates the total return of a longer-term investment with a strategy of rolling over a shorter-term investment. The term may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment. If the market spot rate for a new six-month investment is lower, the investor could use the forward rate agreement to invest the funds from the matured t-bill at the more favorable forward rate. If the spot rate is high enough, the investor could cancel the forward rate agreement and invest the funds at the prevailing market rate of interest on a new six-month investment. For example, the investor will know the spot rate for the six-month bill and will also know the rate of a one-year bond at the initiation of the investment, but they will not know the value of a six-month bill that is to be purchased six months from now.

What Is a Forward Rate?

A forward rate is an interest rate applicable to a financial transaction that will take place in the future. Forward rates are calculated from the spot rate and are adjusted for the cost of carry to determine the future interest rate that equates the total return of a longer-term investment with a strategy of rolling over a shorter-term investment.

The term may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment.

Understanding Forward Rates

In forex, the forward rate specified in an agreement is a contractual obligation that must be honored by the parties involved. For example, consider an American exporter with a large export order pending for Europe, and the exporter undertakes to sell 10 million euros in exchange for dollars at a forward rate of 1.35 euros per U.S. dollar in six months' time. The exporter is obligated to deliver 10 million euros at the specified forward rate on the specified date, regardless of the status of the export order or the exchange rate prevailing in the spot market at that time.

For this reason, forward rates are widely used for hedging purposes in the currency markets, since currency forwards can be tailored for specific requirements, unlike futures, which have fixed contract sizes and expiry dates and therefore cannot be customized.

In the context of bonds, forward rates are calculated to determine future values. For example, an investor can purchase a one-year Treasury bill or buy a six-month bill and roll it into another six-month bill once it matures. The investor will be indifferent if both investments produce the same total return.

For example, the investor will know the spot rate for the six-month bill and will also know the rate of a one-year bond at the initiation of the investment, but they will not know the value of a six-month bill that is to be purchased six months from now.

Forward Rates in Practice

To mitigate reinvestment risks, the investor could enter into a contractual agreement that would allow them to invest funds six months from now at the current forward rate.

Now, fast-forward six months. If the market spot rate for a new six-month investment is lower, the investor could use the forward rate agreement to invest the funds from the matured t-bill at the more favorable forward rate. If the spot rate is high enough, the investor could cancel the forward rate agreement and invest the funds at the prevailing market rate of interest on a new six-month investment.

Related terms:

Currency Forward

A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a hedging tool that does not involve any upfront payment. read more

Derivative

A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more

Exchange Rate

An exchange rate is the value of a nation’s currency in terms of the currency of another nation or economic zone. read more

Forex Spot Rate

The forex spot rate is the most commonly quoted forex rate in both the wholesale and retail market. read more

Forex (FX) , Uses, & Examples

Forex (FX) is the market for trading international currencies. The name is a portmanteau of the words foreign and exchange. read more

Forward Booking

Forward booking is the process of entering into a contract with a booking company, or risk agent, to lock in a specific price for a future date. read more

Futures

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. read more

Future Value (FV)

Future value (FV) is the value of a current asset at a future date based on an assumed rate of growth over time. read more

Inverse Transaction

In financial markets, the term inverse transaction refers to the closing of an open forward contract that has the same value date. read more

Long-Dated Forward

A long-dated forward is a type of forward contract commonly used in foreign currency transactions with a settlement date longer than one year away. read more