Forward Rate vs. Spot Rate: An Overview
The precise meanings of the terms "forward rate" and "spot rate" are somewhat different in different markets. But what they have in common is that they refer, for example, to the current price or bond yield—the spot rate—versus the price or yield for the same product or instrument at some point in the future—the forward rate.
In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or "on the spot". A forward rate is the settlement price of a transaction that will not take place until a predetermined date; it is forward-looking.
In bond markets, the forward rate refers to the effective yield on a bond, commonly U.S. Treasury bills, and is calculated based on the relationship between interest rates and maturities.
- In commodities markets, the spot rate is the price for a product that will be traded immediately, or "on the spot."
- A forward rate is a contracted price for a transaction that will be completed at an agreed upon date in the future.
- In bond markets, forward rate refers to the future yield based on interest rates and maturities.
The Spot and Forward Rates in Commodities Markets
A spot rate, or spot price, represents a contracted price for the purchase or sale of a commodity, security, or currency for immediate delivery and payment on the spot date, which is normally one or two business days after the trade date. The spot rate is the current price quoted for immediate settlement of the contract.
For example, if during the month of August a wholesale company wants immediate delivery of orange juice, it will pay the spot price to the seller and have orange juice delivered within two days.
On the other hand, if the company needs orange juice to be available in late December, but believes the commodity will be more expensive during the winter period due to lower supply, it wouldn't want to make a spot purchase since the risk of spoilage is high. A forward contract would a better fit for the investment. Unlike a spot transaction, a forward contract, involves an agreement of terms on the current date with the delivery and payment at a specified future date.
Spot and Forward Rates in Bond and Currency Markets
The terms spot rate and forward rate are applied a little differently in bond and currency markets. In bond markets, the price of an instrument depends on its yield—that is, the return on a bond buyer's investment as a function of time. If an investor buys a bond that is nearer to maturity, the forward rate on the bond will be higher than the interest rate on its face.
For example, if an investor buys a $1,000, two-year bond with a 10% interest rate, but buys it when there is only one year left until maturity, the yield—or forward rate—will actually be 21%, because he will be returned $1,210 in one year.
In currency markets, the spot rate, as in most markets, refers to the immediate exchange rate. The forward rate, on the other hand, refers to the future exchange rate agreed upon in forward contracts. For example, if a Chinese electronics manufacturer has a large order to be shipped to America in one year, and expects the U.S. dollar to be much weaker by that time, it might be able to transact a currency forward to lock in a more favorable exchange rate.