{“source”:“markdown”,“value”:"# Unlocking the Power of Forward Rates for Future Financial Success
What is a Forward Rate?
A forward rate is an interest rate applied to a financial transaction scheduled for the future. Calculated from the spot rate and adjusted for the cost of carrying, a forward rate determines the future interest rate required to equate the total return of a long-term investment with that of a series of short-term investment rollovers.
The term may also refer to the predetermined interest rate for future financial obligations, like loan payments.
Understanding Forward Rates
In the forex market, an agreed-upon forward rate represents a binding contractual obligation between parties. Consider an American exporter with a substantial pending export order to Europe: the exporter commits to selling 10 million euros in exchange for dollars at a forward rate of 1.35 euros per U.S. dollar in six months\u2019 time. Regardless of the export order status or the prevailing exchange rate in the spot market then, the exporter must deliver 10 million euros at the predetermined forward rate on the specified date.
Forward rates are invaluable for hedging in currency markets, as currency forwards can be crafted to meet specific needs, unlike futures, which come with fixed contract sizes and expiry dates, hence lacking customization.
For bonds, forward rates are computed to ascertain future values. For instance, an investor can buy a one-year Treasury bill or get a six-month bill and renew it with another six-month bill upon maturity. The investor remains indifferent if both investment approaches yield the same total return.
For example, the investor will know the spot rate for the six-month bill and the one-year bond rate at the time of initiating the investment, but the value of another six-month bill to be purchased after six months remains unknown.
Forward Rates in Practice
To counter the risks associated with reinvestment, investors can enter into contracts allowing future fund investments at the prevailing forward rate as of six months ago.
Fast-forward six months. If the market spot rate for a new six-month investment dips, the investor can leverage the forward rate agreement to reinvest matured t-bill funds at the more advantageous forward rate. Conversely, if the spot rate is sufficiently high, the investor may opt out of the forward rate agreement and invest funds at the existing higher market rate for a new six-month investment.
Related Terms: Spot Rate, Currency Forward, Treasury Bill, Exchange Rate, Future Value.
