Definition of forward rate

The term forward rate is commonly used in both bond and currency trading to express today's expectation of the future value of either a currency or a bond.

In bond trading the forward rate is an implied rate calculated from current interest rates on various bond maturities. In theory, it would allow an investor to buy a five year Treasury bond and hold it to maturity, or to buy a one year Treasury and hold it to maturity and repeat the process every year for five years. In practice, it turns out that forward rates tend to be higher than the spot rate that ultimately prevails. In other words, holding longer term bonds will deliver higher average returns.

In currency trading, a forward rate is the rate at which a trader agrees to exchange one currency for another at a set future date. 

 

forward rates in the news

In August 2012, writers in the FT wondered if it might be time to find a more realistic discount rate for pensions that uses expectations about the future rather than data from the past. The writers said: "To a rough approximation, we can measure future expectations by calculating the forward interest rate on risk-free assets, such as US Treasuries or UK gilts. This forward rate, adjusted for the historic spread between Treasuries or gilts and the relevant corporate bond yields, might be a reasonable reflection of expected risk-free returns in the future."

In January 2012, enthusiasm for the renminbi had dimmed. A writer commented that, the spot rate and the 12-month forward rate for the renminbi against the US dollar were about the same at about 6.32, leading to less appetite for renminbi deposits.

FT Articles & Analysis

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