Forward Rate vs. Spot Rate: An Overview
The precise meanings of the terms "forward rate" and "spot rate" are somewhat different in different markets. In general, a spot rate refers to the current price or bond yield, while a forward rate refers to the price or yield for the same product or instrument at some point in the future.
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.
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."
- The spot rate is also known as the cash price since this is what can be exchanged for cash today.
- Buyers and sellers use the spot rate when there is a high need to execute a contract quickly in order to receive/relinquish goods.
- A forward rate is a contracted price for a transaction that will be completed at an agreed-upon date in the future.
- Buyers and sellers use forward rates to hedge risk or explore potential price fluctuations of goods in the future.
- In bond markets, the forward rate refers to the future yield based on interest rates and maturities.
A spot rate or spot price is the real-time price quoted for the instant settlement of a contract. In commodities markets, the spot rate represents the current price for the purchase or sale of a commodity, security, or currency.
A spot rate is associated with the immediate need for a good as the delivery date of the contract normally occurs within two business days of the trade date. Regardless of price fluctuations that occur between the settlement date and the delivery date, the contract will be completed at the agreed-upon spot rate. When contracting with a spot rate, buyers and sellers are mitigating price fluctuation risk by sacrificing potentially favorable future market conditions.
An example of a buyer relying on spot rates is a restaurant that needs fresh ingredients for this week's business. The restaurant has an immediate business need and must pay the current market price in exchange for the goods to be delivered on time. Alternatively, a local farm may have cultivated crops that may go bad if not sold within the next week. The local farm relies on the spot rate to sell their product before the goods expire.
What if the restaurant or farmer didn't need to immediately transaction for the goods? Market participants that are willing to transact in the future rely on the forward rate.
A forward rate is a specified price agreed by all parties involved for the delivery of a good at a specific date in the future. The use of forward rates can be speculative if a buyer believes the future price of a good will be greater than the current forward rate. Alternatively, sellers use forward rates to mitigate the risk that the future price of a good materially decreases.
The difference between the spot rate and forward rate is known as the basis.
Regardless of the prevailing spot rate at the time the forward rate meets maturity, the agreed-upon contract is executed at the forward rate. For example, on January 1st, the spot rate of a case of iceberg lettuce is $50. The restaurant and the farmer agree to the delivery of 100 cases of iceberg lettuce on July 1st at a forward rate of $55 per case. On July 1st, even if the price per case has decreased to $45/case or increased to $65/case, the contract will proceed at $55/case.
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, imagine a $1,000, two-year bond with a 10% interest rate. If the bond is purchased on the issuance date, the expected yield on the bond over the next two years is 10%. If an investor plans on purchasing the bond one year from issuance, the forward rate or price the investor should expect to pay is $1,100 ($1,000 + the 10% accumulated earnings generated from the first year). If the investor is lucky enough to purchase the bond in a year for less than this price, their expected yield will be greater than the coupon rate on the face of the bond.
The forward rate of a commodity, security, or currency can be determined using the current spot rate of the good, and the spot rate can be determined using the forward rate. This relationship closely mirrors the relationship between a discounted present value and a future value. As long as an expected yield rate is known and the timeframe has been determined, the change from spot rate to forward rate is an exercise of converting a present value to a future value or vice versa.
This calculation is slightly different for bond markets, as different bonds with varying terms can be compared to determine forward rates. For example, imagine a two-year bond paying 7.5% and a one-year bond paying 6.5%. Subtracting the two-year bond's future value from the one-year bond's future value a year from now results in the expected one-year forward rate.
How Do You Calculate the Forward Rate?
The forward rate for a bond is calculated by comparing the future expected yield of two bonds. The forward rate is the yield that will be earned if proceeds from the bond maturing earlier are then re-invested to match the term of the bond maturing later.
The steps to calculate the forward rate are:
- Determine the expected future return of the two-year bond. This is calculated as ((1 + rate) ^ term). In this example, the value is 1.15562.
- Determine the expected future return of the one-year bond. This is calculated as ((1 + rate) ^ term). In this example, the value is 1.065%.
- Divide the results obtained in steps 1 and 2. In this example, the result is 1.0851%.
- Divide the result obtained in step 3 by the difference in the number of periods between the two bonds, then subtract 1 from the result. In this example, 1.0851% is divided by 1 (2 years - 1 year), and 1 is subtracted. The result of 8.5% is the one-year forward rate.
What Is a Forward Rate Agreement?
A forward rate agreement is a contractual obligation where two parties agree to a specific transaction price for delivery on a specific day. The forward rate will likely differ from the spot rate as both the buyer and seller are motivated to enter into an agreement for a fixed price to be paid in the future.
What Is a Spot Rate in Foreign Exchange?
A spot rate in foreign exchange is the current exchange rate between two currencies. It is the price to be paid today for immediate settlement in an exchange of two currencies.