What’s a forward rate?
Forward rates are interest rates for future financial transactions. Based on spot rates and carrying costs, forward rates determine future interest rates that balance the return of long-term investments with those of shorter-term investments.
The phrase can also allude to a future financial responsibility, like a loan interest rate.
Understanding
In forex, parties must honor the predetermined forward rate as a contractual obligation. For instance, an American exporter with a sizeable European export order agrees to sell 10 million euros for dollars at an advance rate of 1.35 euros per U.S. dollar in six months. The exporter must provide 10 million euros at the stipulated forward rate on the given date. No matter the state of the export order or the currency rate in the spot market,
Forward rates are commonly utilized to hedge in currency markets since they can be modified to meet particular needs, unlike futures, which have set contract amounts and expiration dates.
For bonds, the rates determine future prices. An investor may buy a one-year Treasury note or a six-month bill and roll it into another six-month statement at maturity. If two investments provide the same return, the investor is indifferent.
The investor may know the spot rate for a six-month bill. They may also know the rate of a one-year bond at the start of the investment but not the bill’s value six months later.
Forward Rates in Practice
Investors may sign contracts to invest at the current advance rate six months from now to decrease reinvestment risks.
Move ahead for six months. Using the advance rate agreement, the investor might invest matured t-bill money at a lower spot rate for six months. If spot rates are high enough, the investor can terminate the rate agreement and invest in a six-month market.
