Forward Rate

If you know the interest rate for borrowing for one year and for two years, you can work out the rate the market implies for borrowing for the second year alone. That is the one-year forward rate starting in one year.

For example, if the one-year spot rate is 4% and the two-year spot rate is 5%, investing for two years at 5% grows 1 to 1.1025. Investing for one year at 4% grows it to 1.04. For both routes to give the same result, the rate for the second year must be about 6.0%, which is the implied forward rate.

Forward rates are used to price forward rate agreements, interest rate swaps and other derivatives, and to compare investment choices. They reflect market expectations of future interest rates, together with a premium for the risk of holding longer-term bonds, so they are not pure forecasts.

In foreign exchange, the term forward rate means the exchange rate agreed today for exchanging currencies at a future date, which depends on the interest rate difference between the two currencies.