Forward rate

The forward rate is the future yield on a bond. It is calculated using the yield curve. For example, the yield on a three-month Treasury bill six months from now is a forward rate.[1]

Not to be confused with forward price or forward exchange rate.

Forward rate calculation

To extract the forward rate, we need the zero-coupon yield curve.

We are trying to find the future interest rate ${\displaystyle r_{1,2}}$ for time period ${\displaystyle (t_{1},t_{2})}$, ${\displaystyle t_{1}}$ and ${\displaystyle t_{2}}$ expressed in years, given the rate ${\displaystyle r_{1}}$ for time period ${\displaystyle (0,t_{1})}$ and rate ${\displaystyle r_{2}}$ for time period ${\displaystyle (0,t_{2})}$. To do this, we use the property that the proceeds from investing at rate ${\displaystyle r_{1}}$ for time period ${\displaystyle (0,t_{1})}$ and then reinvesting those proceeds at rate ${\displaystyle r_{1,2}}$ for time period ${\displaystyle (t_{1},t_{2})}$ is equal to the proceeds from investing at rate ${\displaystyle r_{2}}$ for time period ${\displaystyle (0,t_{2})}$.

${\displaystyle r_{1,2}}$ depends on the rate calculation mode (simple, yearly compounded or continuously compounded), which yields three different results.

Mathematically it reads as follows:

Simple rate

${\displaystyle (1+r_{1}t_{1})(1+r_{1,2}(t_{2}-t_{1}))=1+r_{2}t_{2}}$

Solving for ${\displaystyle r_{1,2}}$ yields:

Thus ${\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}\left({\frac {1+r_{2}t_{2}}{1+r_{1}t_{1}}}-1\right)}$

The discount factor formula for period (0, t) ${\displaystyle \Delta _{t}}$ expressed in years, and rate ${\displaystyle r_{t}}$ for this period being ${\displaystyle DF(0,t)={\frac {1}{(1+r_{t}\,\Delta _{t})}}}$, the forward rate can be expressed in terms of discount factors: ${\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}\left({\frac {DF(0,t_{1})}{DF(0,t_{2})}}-1\right)}$

Yearly compounded rate

${\displaystyle (1+r_{1})^{t_{1}}(1+r_{1,2})^{t_{2}-t_{1}}=(1+r_{2})^{t_{2}}}$

Solving for ${\displaystyle r_{1,2}}$ yields :

${\displaystyle r_{1,2}=\left({\frac {(1+r_{2})^{t_{2}}}{(1+r_{1})^{t_{1}}}}\right)^{1/(t_{2}-t_{1})}-1}$

The discount factor formula for period (0,t) ${\displaystyle \Delta _{t}}$ expressed in years, and rate ${\displaystyle r_{t}}$ for this period being ${\displaystyle DF(0,t)={\frac {1}{(1+r_{t})^{\Delta _{t}}}}}$, the forward rate can be expressed in terms of discount factors:

${\displaystyle r_{1,2}=\left({\frac {DF(0,t_{1})}{DF(0,t_{2})}}\right)^{1/(t_{2}-t_{1})}-1}$

Continuously compounded rate

EQUATION→ ${\displaystyle e^{{(r}_{2}\ast t_{2})}=e^{{(r}_{1}\ast t_{1})}\ast \ e^{\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}}$

Solving for ${\displaystyle r_{1,2}}$ yields:

STEP 1→ ${\displaystyle e^{{(r}_{2}\ast t_{2})}=e^{{(r}_{1}\ast t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}}$

STEP 2→ ${\displaystyle \ln {\left(e^{{(r}_{2}\ast t_{2})}\right)}=\ln {\left(e^{{(r}_{1}\ast t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}\right)}}$

STEP 3→ ${\displaystyle {(r}_{2}\ast \ t_{2})={(r}_{1}\ast \ t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}$

STEP 4→ ${\displaystyle r_{1,2}\ast \left(t_{2}-t_{1}\right)={(r}_{2}\ast \ t_{2})-{(r}_{1}\ast \ t_{1})}$

STEP 5→ ${\displaystyle r_{1,2}={\frac {{(r}_{2}\ast t_{2})-{(r}_{1}\ast t_{1})}{t_{2}-t_{1}}}}$

The discount factor formula for period (0,t) ${\displaystyle \Delta _{t}}$ expressed in years, and rate ${\displaystyle r_{t}}$ for this period being ${\displaystyle DF(0,t)=e^{-r_{t}\,\Delta _{t}}}$, the forward rate can be expressed in terms of discount factors:

${\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}(\ln DF(0,t_{1})-\ln DF(0,t_{2}))}$

${\displaystyle r_{1,2}}$ is the forward rate between time ${\displaystyle t_{1}}$ and time ${\displaystyle t_{2}}$,

${\displaystyle r_{k}}$ is the zero-coupon yield for the time period ${\displaystyle (0,t_{k})}$, (k = 1,2).

Related instruments

• Forward rate agreement
• Floating rate note

See also

• Forward price
• Spot rate

References

1. Fabozzi, Vamsi.K (2012), The Handbook of Fixed Income Securities (Seventh ed.), New York: kvrv, p. 148, ISBN 0-07-144099-2.