Forward rates can also be used to lock in rates on future foreign exchanges. For example, suppose you’re buying a home in Mexico in six months, but the exchange rate from U.S. dollars (USD) to Mexican pesos (MXN) is historically low right now. You could lock in a forward rate agreement with a bank so you can still pay that same currency exchange rate when you’re ready to buy.
How a Forward Rate Works
Forward rates are used to estimate the interest rate you could get on a bond and other securities you may be thinking about buying in the future. You can calculate the forward rate using the yield curve (for government bonds with various maturities) or the spot rate (for zero-coupon bonds). The general forward rate formula looks like this: For example, let’s say you want to invest in bonds. After shopping around, you narrow it down to two options:
A one-year zero-coupon bond earning 9%A two-year zero-coupon bond earning 10%
You want to know what the one-year forward rate would be over the second year of the two-year bond. So you use this equation to figure it out: So, by going with the two-year zero-coupon bond, you’re essentially locking in a forward rate of 11% for the second year. Locking in a forward rate on a loan or currency exchange can be helpful if you’re worried about future interest-rate volatility.
What Forward Rates Mean for Individual Investors
Forward rates on currency exchanges are mostly used by businesses. Suppose you own a large business that has relations with a supplier in Canada. You have a $500,000 bill coming due in six months, and you know you’ll need to exchange a large sum of currency. You have two options:
Forward Rate vs. Spot Rate
Another key difference is that spot rates fluctuate with the market, so they’re subject to change at any time. Future rates, on the other hand, are predetermined, so you know now what the rate will be in the future.
Disadvantages of a Forward Rate
While a forward rate can be helpful in managing interest-rate risk, it’s important to keep in mind that it’s not without its limitations. First and foremost, a forward rate is only an estimate. It becomes less reliable the further you estimate into the future. So it can be good if you’re trying to estimate rates for a few months or a year, but beyond that, the accuracy of a forward rate starts to wane.
