The calculated expectation of the yield on a bond in the immediate future
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The forward rate, in simple terms, is the calculated expectation of the yield on a bond 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 bills, more commonly known as T-bills.
Exploring the Forward Rate
The forward rate can be calculated using one of two metrics:
Yield curve – The relationship between the interest rates on government bonds of various maturities
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 rates 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
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 advisor.
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.
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