Forward Rate

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DEFINITION of 'Forward Rate'

A rate applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time. It may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment.

INVESTOPEDIA EXPLAINS 'Forward Rate'

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 undertakes to sell 10 million euros in exchange for dollars at a 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 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. 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 they both produce the same result. The investor will know the spot rate for the six-month bill and the one-year bond, but he or she will not know the value of a six-month bill that is purchased six months from now. Given these two rates though, the forward rate on a six-month bill will be the rate that equalizes the dollar return between the two types of investments mentioned earlier.

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RELATED FAQS
  1. How is a share premium account taxed?

    The two main differences between a spot rate and a forward rate are the timing of delivery of a commodity, security or currency ... Read Full Answer >>
  2. How valuable is the forward rate as an overall economic indicator?

    Any given forward rate is theoretically equal to its corresponding spot rate plus future expectations. Many investors and ... Read Full Answer >>
  3. What is the difference between a forward rate and a spot rate?

    The forward rate and spot rate are different prices, or quotes, for different contracts. The forward rate is the settlement ... Read Full Answer >>
  4. What kinds of derivatives are types of forward commitments?

    A derivative is a type of security in which the price of the security is dependent on underlying assets. A derivative could ... Read Full Answer >>
  5. What does the underlying of a derivative refer to?

    A derivative security is a financial instrument in which the price of the derivative is dependent on its underlying asset. ... Read Full Answer >>
  6. How can an investor terminate a derivative contract?

    Most derivatives contracts have provisions allowing for early termination and netting out the initial investment. The early ... Read Full Answer >>
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