Understanding Forward Rates: A Comprehensive Guide

The forward rate, in simple terms, is the calculated expectation of the yield on a bondBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. that, theoretically, will occur in the immediate future, usually a few months (or even a few years) from the time of calculation. The consideration of the forward rate is almost exclusively used when talking about the purchase of Treasury billsTreasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument issued by the US Treasury with maturity periods from a few days up to 52 weeks., more commonly known as T-bills.

Exploring the Forward Rate

The forward rate can be calculated using one of two metrics:

1. Yield curve – The relationship between the interest rates on government bonds of various maturities
2. Spot rates – The assumed yield on a zero-coupon Treasury security

Spot rates are not as commonly used for calculating the forward rate. The yield curve clearly identifies what present-day bond prices and interest ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. are. It also goes beyond that by providing reasonable suggestions for what the market postulates future interest rates are likely to be. The nature of the yield curve lends itself to being a near-perfect metric for determining the forward rate.

Understanding the Significance of the Forward Rate

To better understand the use and significance of the forward rate, look at the example below.

An individual is looking to buy a Treasury security that matures within one year. They are then presented with two basic investment options:

1. Purchase one T-bill that matures after six months and then purchase a second six-month maturity T-bill

-or-

2. Purchase a single T-bill that matures in 12 months/one year

The received yield on the first option may be more variable because interest rates may/are likely to change between the purchase of the first and second six-month maturity T-bills. If there were a guarantee that interest rates would stay the same, the individual would likely not give a second thought to which option to go with.

The reality, however, is that interest rates may very well shift when the investor rolls the first T-bill investment into the second. If rates are higher, then the individual would obviously make more money by pursuing the first option – buying one T-bill and then a second.

However, the rate on six-month T-bills could also drop. In that case, the investor would’ve received a higher total yield by choosing the second option – purchasing a single one-year T-Bill.

In order to make the best decision in such a scenario – the decision most likely to return the highest possible yield for the investor – it can be helpful to look at the forward rate. Again, this is simply the projected estimate of where interest rates are most likely to be six months from the time of the investor’s initial T-bill purchase.

Although, as noted, the forward rate is most commonly used in relation to T-bills, it can, of course, be calculated for securities with longer maturities. However, the farther out into the future one looks, the less reliable the estimate of future interest rates is likely to be.

Using the Forward Rate

There are three different calculations for the forward rate that an investor can look at – simple, yearly compounded, or continuously compounded rates. Each of the interest rate calculations will be slightly different. It’s up to the individual to choose which calculation they believe is the most reliable at that particular point in time.

Regardless of which version is used, knowing the forward rate is helpful because it enables the investor to choose the investment option (buying one T-bill or two) that offers the highest probable profit.

The actual calculation is rather complex. Fortunately, an investor can simply look up the current projected forward rate on any one of a number of financial information websites or just by inquiring with their brokerage firm or financial advisorFinancial Analyst vs Financial AdvisorFinancial Analyst vs Financial Advisor: A financial analyst performs financial assessments for a business. A financial advisor offers guidance to clients or investors.

Summary

Keep in mind that the forward rate is simply the market’s best estimate of where interest rates are likely to be at some specified point in the future. Therefore, the current projected forward rate may or may not prove to be accurate.

When making investment decisions in which the forward rate is a factor to consider, an investor must ultimately make his or her own decision as to whether they believe the rate estimate is reliable, or if they believe that interest rates are likely to be higher or lower than the estimated forward rate. Still, looking at the rate at least provides the investor with a reasonable basis on which to make their investment choice.

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Coupon RateCoupon RateA coupon rate is the amount of annual interest income paid to a bondholder, based on the face value of the bond.
• Discount BondDiscount BondA discount bond is a bond that is issued at a lower price than its par value or a bond that is trading in the secondary market at a price that is below the par value. It is similar to a zero-coupon bond, only that the latter does not pay interest. A bond is considered to trade at a discount
• Floating Rate NoteFloating Rate NoteA floating rate note (FRN) is a debt instrument whose coupon rate is tied to a benchmark rate such as LIBOR or the US Treasury Bill rate. Thus, the coupon rate on a floating rate note is variable. It is typically composed of a variable benchmark rate + a fixed spread.
• Interest Rate RiskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments.