:max_bytes(150000):strip_icc():format(jpeg)/GettyImages-2042631749-b4f851641f7c4fe78d8d2b88b58604f4.jpg "Woman holding a pen and looking at a laptop")
pixelfit / Getty Images
Reviewed by Charles PottersFact checked by Suzanne KvilhaugReviewed by Charles PottersFact checked by Suzanne Kvilhaug
Investors and fund managers use forward rates to assess potential returns on international investments, bonds, and many other assets. For example, in foreign exchange trading (forex or FX), the expected change in exchange rates, as indicated by forward rates, can significantly affect the return on foreign investments. Thus, understanding the relationship between spot and forward rates is crucial for traders, investors, and multinational firms.
Key Takeaways
- Forward interest rates act as a discount rate for a single payment from one future date and discounts it to a closer future date.
- Theoretically, the forward rate should equal the spot rate plus any earnings from the security (and any finance charges).
- This principle is illustrated in equity forward contracts, where the differences between forward and spot prices are based on dividends payable, less interest payable during the period.
- To understand the differences and relationship between spot rates and forward rates, it helps to think of interest rates as the price of financial transactions.
While spot rates represent the present price of an asset, forward rates offer a glimpse into the future, predicting the price for transactions that will occur later. You need the forward rate formula to take one and convert it into the other.
Rooted in economic principles and interest rate differences, it allows market participants to calculate expected future prices based on present market conditions. It’s not merely an academic exercise: the ability to accurately estimate forward rates can mean the difference between profitable trades and costly missteps.
Below, we’ll break down the formula’s components, explore its practical applications, and show why it’s important when navigating different markets.
Why Convert From Spot Rate to Forward Rate
Theoretically, the forward rate should equal the spot rate, plus any earnings from the security (and any finance charges). You can see this principle in equity forward contracts, where the differences between forward and spot prices are based on dividends payable, less interest payable during the period.
A spot rate is used by buyers and sellers looking to make an immediate purchase or sale, while a forward rate accounts for the market’s expectations for future prices. It can serve as an economic indicator of how the market expects the future to perform, while spot rates are not indicators of market expectations. Instead, spot rates are the starting point for any financial transaction.
So, it is normal for investors to use forward rates if they believe they have knowledge or information on how the prices of specific items will move over time. If a potential investor believes that real future rates will be higher or lower than the present-day forward rates, this would be an investment prospect.
Key Differences Between Spot and Forward Rate
Here are the key differences between spot and forward rates.
Time Frame/Settlement
Spot rates apply to the present. It’s the price to take delivery now or very soon. Forward rates are agreed upon today for a transaction that takes place on a future fixed date, which could be days, months, or years ahead.
Pricing
The spot rate is determined by the present supply and demand. The forward rate factors in the spot rate, any earnings or charges due or owed over the time frame, and expectations about the asset’s future returns and price direction.
Usage
The spot rate is used for immediate transactions where the buyer wants to take ownership straight away. The forward rate, meanwhile, is commonly used to hedge risk or exploit potential price fluctuations.
Volatility
The spot rate is subject to constant fluctuations. The forward rate, once agreed upon in a contract, remains fixed.
Converting From Spot to Forward Rate
For simplicity, let’s consider how to calculate the forward rates for zero-coupon bonds. A basic formula for calculating forward rates looks like this:
Forward rate=(1+rb)tb(1+ra)ta−1where:ra=The spot rate for the bond of term ta periodsrb=The spot rate for the bond with a shorter term of tb periods
In the formula, “a” is the end future date (for example, five years), and “b” is the closer future date (for example, three years), based on the spot rate curve.
Suppose a two-year bond yields 10% while a one-year bond yields 8%. The return from the two-year bond is the same as if an investor receives 8% for the one-year bond and then rolls it over into another one-year bond at 12.04%.
Forward rate=(1+0.08)1(1+0.10)2−1=0.1204=12.04%
This hypothetical 12.04% is the forward rate of the investment.
To see the relationship again, suppose the spot rate for a three-year and four-year bond is 7% and 6%, respectively. A forward rate between years three and four—the equivalent rate required if the three-year bond is rolled over into a one-year bond after it matures—would be 3.06%.
Example of Using Spot and Forward Rates
To understand the relationship between spot rates and forward rates, it helps to think of interest rates as the price of financial transactions. Consider a $1,000 bond with an annual coupon of $50. The issuer is essentially paying 5% ($50) to borrow the $1,000.
A “spot” interest rate tells you what the price of a financial contract is on the spot date, which is normally within two days after a trade. A financial instrument with a spot rate of 2.5% is the agreed-upon market price of the transaction based on present buyer and seller action.
Forward rates are theorized prices of financial transactions that might take place at some point in the future. The spot rate answers the question, “How much would it cost to execute a financial transaction today?” The forward rate answers the question, “How much would it cost to execute a financial transaction at future date X?”
Note that both spot rates and forward rates are agreed upon in the present. It’s the timing of the execution that’s different. A spot rate is used if the agreed trade occurs today or tomorrow. A forward rate is used if the agreed trade isn’t set to occur until later in the future.
Main Users of Spot and Forward Rates
Spot rates are used to determine the immediate cost of purchasing an interest rate, commodity, security, or currency. They are widely used, including by people traveling to a country with a different currency, investors, and companies that buy in commodities and do business internationally.
The main users interested in market spot rates include broker-dealers, central banks, commercial banks, asset managers, high-frequency trading firms, and speculators.
Companies use forward rates to hedge risks associated with currency fluctuations or interest rate changes or to fix the cost of a commodity they need. This makes it easier to budget, manage costs, determine pricing, and rule out potential nasty surprises. Banks and financial institutions use forward rates to price loans, manage their asset-liability mix, and develop complex financial products.
Investors also use forward rates to hedge against another position they took or purely to make a profit. For example, an investor may believe the price of oil will rise more than the forward rate being quoted.
Spot and Forward Rates in Forex
In forex, you would use the above formula this way to find forward forex rates:
Forward Rate = Spot Rate × (1 + Interest Rate of Currency A)T / (1 + Interest Rate of Currency B)T
Where:
- Spot Rate is the present exchange rate
- Interest rate of currency A is the interest rate of the base currency. (Currency pairs are written as XXX/YYY or simply XXXYYY, where XXX is the base currency and YYY is the quote currency.)
- Interest rate of Currency B is the interest rate of the quote currency
- T is the time in years
Example
Let’s consider an example. Suppose we want to calculate the one-year forward rate for USD/EUR.
Given:
- Current spot rate: 1 USD = 0.85 EUR
- One-year interest rate for USD: 2%
- One-year interest rate for EUR: 1%
- Period: One year
Here’s the calculation:
Forward Rate = 0.85 × (1 + 0.02)1 / (1 + 0.01)1
= 0.85 × 1.02 / 1.01
= 0.85 × 1.00990099
= 0.8584
So, the one-year forward rate would be approximately 1 USD = 0.8584 EUR.
Why the Formula Matters in Forex
The ability to convert spot rates to forward rates is crucial for several reasons:
- Arbitrage opportunities: Traders analyze discrepancies between spot rates, forward rates, and interest rate differentials to identify potential arbitrage prospects. While these are often short-lived in efficient markets, the ability to quickly calculate and compare rates is crucial.
- Economic indicators: Forward rates can help clarify market expectations for future economic conditions, inflation rates, and monetary policy changes in different countries. Central banks and economists often study these rates in their broader economic analysis.
- Financial planning: Multinational corporations use forward rates to forecast expenses and revenues in different currencies. This allows for better budgeting and financial projections. Imagine a tech company with offices in Paris and New York trying to plan next year’s budget—forward rates are essential for this process.
- Investment decisions: Investors and fund managers use forward rates to assess potential returns on international investments. The expected change in exchange rates, as indicated by forward rates, can significantly impact the overall return of a foreign investment when converted back to the investor’s home currency.
- Pricing financial instruments: Many financial products, such as currency swaps and foreign exchange options, rely on forward rate calculations in their pricing models. It would be challenging to fairly price these derivatives without an accurate way to determine forward rates.
- Risk management: Companies engaged in international trade often need to hedge against currency fluctuations. By calculating forward rates, businesses can lock in exchange rates for future transactions, protecting themselves from adverse currency shifts. For example, a U.S. manufacturer expecting a large euro payment in six months can use the forward rate to determine if it should hedge now or wait.
Forward Premium Puzzle
The forward premium puzzle (also known as the forward bias or the forward premium anomaly) is an important consideration when using the above conversion formula. In theory, the formula for converting spot rates to forward rates should provide an unbiased predictor of future spot rates. This is based on the concept of covered interest rate parity.
This principle suggests that the difference in interest rates between two currencies should be offset by the expected change in the exchange rate between those currencies. In other words, the higher-yielding currency is expected to depreciate against the lower-yielding currency by an amount that equalizes the overall returns.
In efficient markets, interest rate parity should prevent risk-free arbitrage opportunities between different currencies. However, deviations from interest rate parity do occur in practice, leading to phenomena like the forward premium puzzle and creating potential profits for savvy traders and investors.
Empirical evidence thus consistently shows that the forward rate is not an unbiased predictor of the future spot rate. In fact, currencies with higher interest rates tend to appreciate relative to those with lower interest rates, contrary to what the theory suggests. Researchers have proposed various explanations for this puzzle, including risk premiums, the possibility of rare but large events, and behavioral factors.
This challenges the supposition of the efficiency of foreign exchange markets and the full validity of uncovered interest rate parity, a cornerstone of international finance theory.
Thus, while the formula for converting spot rates to forward rates remains serviceable for many purposes (hedging, contractual agreements, etc.), the forward premium puzzle suggests that simply using this formula to predict future exchange rates or make speculative decisions could lack the exactness that having a ready-made formula suggests.
What Is an Example of a Spot Rate?
The spot rate is the price the subject is being sold for if you were to pay and take possession of it immediately or in the very near future. That could be a commodity, such as bananas or Brent crude; the exchange rate of a currency pair; or a company’s share price.
How Is the Spot Exchange Rate Calculated?
It’s computed by taking the midpoint between its bid and ask prices. This is the middle point between the price at which brokers are willing to sell and what buyers are willing to pay.
Why Are Forward Rates Above Spot Rates?
Forward rates aren’t necessarily always above spot rates. A lot depends on economic and market conditions and the asset in question. Generally, securities are expected to rise in value, which usually justifies a higher price in the future. With physical commodities, there’s also the issue of storage costs and insurance if you take delivery immediately, which must be factored into the various prices. However, when inflation begins to cool, interest rates are likely to be cut. This results in a yield curve that slopes downward and a spot rate that is higher than forward rates.
The Bottom Line
Knowing how to convert the spot rate to the forward rate can help investors and businesses potentially make and save money.
A spot rate is used for immediate purchase or sale, while a forward rate is the rate you agree to pay for the transaction on a specific date in the future, which could be days, weeks, months, or years away. In theory, the forward rate should be the spot rate, plus any earnings and less any charges, but the forward premium puzzle shows that they’re often not.
Read the original article on Investopedia.