What Is a Forward Rate?

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DEFINITION
A forward rate is the interest rate that will be paid on a loan or investment that's made in the future. It’s called a forward rate because it happens “forward in time.”

A forward rate is the interest rate that will be paid on a loan or investment that's made in the future. It’s called a forward rate because it happens “forward in time.”

Here’s a closer look at what a forward rate is, how it works, and how it differs from a spot rate.

Definition and Example of a Forward Rate

A forward rate is the potential interest rate you could earn on a bond, loan, or other financial transaction that will take place in the future.

Forward rates can also be used to lock in rates on future foreign exchanges. For example, suppose you’re buying a home in Mexico in six months, but the exchange rate from U.S. dollars (USD) to Mexican pesos (MXN) is historically low right now. You could lock in a forward rate agreement with a bank so you can still pay that same currency exchange rate when you’re ready to buy.

Forward rates are important concepts to understand in macroeconomics, as they’re used to forecast market expectations.

How a Forward Rate Works

Forward rates are used to estimate the interest rate you could get on a bond and other securities you may be thinking about buying in the future.

You can calculate the forward rate using the yield curve (for government bonds with various maturities) or the spot rate (for zero-coupon bonds).

The general forward rate formula looks like this: 

fn = [ (1+rn)n / (1+rn-1)n-1 ] - 1

fn = the forward rate over the nth year

rn = the n-year spot rate

rn-1 = the spot rate for n - 1 years

For example, let’s say you want to invest in bonds. After shopping around, you narrow it down to two options:

  • A one-year zero-coupon bond earning 8%
  • A two-year zero-coupon bond earning 10%

You want to know what the one-year forward rate would be over the second year of the two-year bond. So you use this equation to figure it out.

[ (1.10)2 / (1.09)1 ] - 1

1.21 / 1.09 = 1.11 or 11%

So, by going with the two-year zero-coupon bond, you’re essentially locking in a forward rate of 11% for the second year.

Locking in a forward rate on a loan or currency exchange can be helpful if you're worried about future interest-rate volatility.

What Forward Rates Mean for Individual Investors

Forward rates on currency exchanges are mostly used by businesses. Suppose you own a large business that has relations with a supplier in Canada. You have a $500,000 bill coming due in six months, and you know you’ll need to exchange a large sum of currency. You have two options:

  1. You can wait one year and do the transaction at the current exchange rate (this would be a spot transaction).
  2. You can lock in the terms of the transaction today using a future contract (this is called hedging).

If you’re afraid exchange rates will be less favorable in the future, you could lock in a forward rate with a bank to help minimize risk and protect your profit margins.

Forward Rate vs. Spot Rate

Forward Rate Spot Rate
Agreed-upon interest rate of a transaction made in the future Current interest rate of a transaction made now
Forward rates are locked in for a future date Spot rates mark a moment in time, so they change as markets rise and fall

Pretty much anytime someone mentions the forward rate, they’ll also mention the spot rate. The main difference is that a forward rate applies to transactions made in the future, while a spot rate applies to transactions that are happening now (usually within the next two business days).

Another key difference is that spot rates fluctuate with the market, so they’re subject to change at any time. Future rates, on the other hand, are predetermined, so you know now what the rate will be in the future.

Disadvantages of a Forward Rate

While a forward rate can be helpful in managing interest-rate risk, it's important to keep in mind that it's not without its limitations.

First and foremost, a forward rate is only an estimate. It becomes less reliable the further you estimate into the future. So it can be good if you’re trying to estimate rates for a few months or a year, but beyond that, the accuracy of a forward rate starts to wane.

Key Takeaways

  • A forward rate is the interest rate that will be paid on a loan or investment made in the future.
  • A forward rate is an important tool for predicting future interest rates and for hedging against changes in those rates.
  • Forward rates can be helpful when making investing decisions if you're concerned about future interest-rate volatility.

Article Sources

  1. Customs and Border Protection. "Foreign Currency Exchange Rates." 

  2. Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, and Bradford Jordan. "Corporate Finance. 12th Edition," Chapter 5, Appendix 5A.

  3. Export.gov. "Foreign Exchange (FX) Risk Management."