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 he or she 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 him or her 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.