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Forward Rate: Definition & Formula Video

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  • 0:04 Forward Interest Rate
  • 1:05 The Spot Rate
  • 1:47 Forward Interest Rate…
  • 3:00 Foreign Exchange Rates
  • 5:07 Lesson Summary
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Lesson Transcript
Instructor: Sanghamitra Das

Sanghamitra has a master's in Finance and has a professional working and teaching experience of over a decade.

Exchange rates keep fluctuating every day, and so do the financial market interest rates. These movements may seem small, but they make a big impact on high volume monetary transactions. Locking transactions in forward rates helps to control losses that may ensue from the volatility of the rates.

Forward Interest Rate

A forward rate can be of two types: forward interest rate and forward exchange rate. Let's start with forward interest rate.

forwardrates

A forward interest rate is a financial rate usually associated with a contract that will be executed at a future date. It's also known as future yield on a debt instrument known as a bond. A forward rate arises because of the terms of a forward contract. There are two commitments of performance that lead to successful execution of a forward contract. The first commitment is to deliver, sell, or take a short position on the asset, and this could be the seller's commitment. The second commitment is to take delivery, buy, or take a long position on the asset, and this could be the buyer's commitment.

Let's imagine that an oil trader is expecting a shipment of oil in about four months. But because oil is a price sensitive commodity, its rate could be uncertain. The oil trader enters into a forward contract to buy oil from the seller. Through this contract, both parties agree to fix a rate of interest in advance at time ''t,'' which is relevant to time zero, or the starting time of the contract.

The Spot Rate

Before we proceed to understand how a forward rate is calculated, we need to familiarize ourselves with spot rates. Spot rates are associated with spot contracts. A spot contract deals with buying or selling an underlying tradable item with settlement and delivery on the same day. Settlement here indicates payment, and delivery refers to the transfer of the title of the underlying item mentioned in the contract. The settlement price here is known as the spot rate. If the agreement of the contract is fixed today like that of a spot contract but the payment and delivery happens at a future decided date (unlike in a spot rate), the contract becomes a forward contract. The predetermined settlement price of the forward contract is actually the forward rate.

Forward Interest Rate Calculation

Let us look at the rates below and try to calculate the forward rates.

Year Spot Interest Rates
1 6%
2 7%
3 8%
4 7%

The forward rate and the spot rate in Year 1 will be equal. Forward rates are usually calculated one year ahead as shown below:

FR y^2 = {(1.07)2/1.06} -1 = 8%
FR y^3 = {(1.08)3/ (1.07)2} - 1 = 10.02%
FR y^4 = {(1.07)4/ (1.08)3} - 1 = 4.05%

Let us assume an investor willing to invest in a contract with $1 in a two-year forward contract. At the end of the term the amount to be received is $1.1449 ($1 * (1.07)2). Technically, the investor is receiving a one-year spot rate of 6%, and for the second year he is receiving a forward rate of 8%. Now, if he wishes to invest $1 in a three-year forward contract, he will receive $1.2597 ($1 * (1.08)3). Here he would be receiving a two-year spot rate of 7% and forward rate of 10.2% over the third year. Finally, if he wishes to invest $1 in a four-year forward contract, he will receive $1.3107 ($1 * (1.07)4). Here, the investor would be receiving 8% spot rate for the first three years and a forward rate of 4.05% the fourth year. The returns reduce because the forward rates are linked to spot rates, and the fourth year's spot rate is a percentage point lower at 7%.

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