In finance, a forward rate is a rate applicable to a financial transaction that will take place at a specified future date. It is essentially the interest rate that is locked in today for a loan that will occur in the future.
Forward rates are most commonly used in bond markets, where the future interest rates on bonds are determined based on current conditions in the financial markets. They are also used in foreign exchange markets in the form of forward exchange rates for future currency exchanges.
Forward rates are calculated from the current spot rate and take into account the interest rate differentials between the two points in time. They are typically derived from the yield curve, which is a graphical representation of interest rates on debt for a range of maturities.
In the context of a forward rate agreement (FRA), it refers to the fixed rate agreed upon in the contract, which will be compared against the future spot rate when the FRA matures.
Importantly, a forward rate is a purely mathematical calculation that does not take into account expectations or predictions about future interest rate changes. As such, while it provides a reference point, it may not necessarily reflect the actual interest rate that will prevail in the future.
Example of Forward Rate
Let’s consider a scenario in the foreign exchange market. Suppose a U.S. company knows it will have to pay 1 million euros to a European supplier in six months. The current exchange rate, known as the spot rate, is 1.10 USD/EUR. However, the company is worried that the euro will appreciate against the dollar, making the payment more expensive in dollar terms.
To hedge this risk, the U.S. company can enter into a forward contract with its bank. The bank quotes a six-month forward rate of 1.12 USD/EUR. This means that the company can agree today to buy 1 million euros for 1.12 million dollars in six months, no matter what happens to the actual exchange rate.
Here, the forward rate of 1.12 USD/EUR is the exchange rate agreed upon today for the transaction taking place in the future.
It’s important to note that the forward rate may not be equal to the future spot rate. If the spot rate in six months is 1.15 USD/EUR, then the company will have benefited from entering the forward contract, because it will pay less than the prevailing exchange rate. Conversely, if the spot rate in six months is 1.08 USD/EUR, the company will end up paying more than if it had not entered the forward contract.