Forward Rate vs Spot Rate: What’s the Difference?

Forward rate vs. spot rate: an overview

A spot rate is the current price at which a commodity, currency, or security can be bought. A forward rate is the future price that a forex trader agrees to, or the yield on a bond at a future date.

In commodity futures markets, the spot rate is the price for a commodity that is traded immediately, or “on the spot.” A key difference between the two terms in the commodity markets is that traders use “forward price” instead of “forward rate” because it is the settlement price of a transaction that only takes place on a predetermined date – and doesn’t for a course.

In the bond markets, the forward rate refers to the effective yield on a bond, typically US Treasury bills, and is calculated based on the relationship between interest rates and maturities.

The central theses

• In the commodity markets, the spot rate is the price for a product that is traded immediately, or “on the spot.”
• Buyers and sellers use the spot rate when there is a high need to execute a contract quickly to receive/deliver goods.
• A forward rate is a contractually agreed price for a transaction to be completed at an agreed future date.
• Buyers and sellers use futures rates to hedge risks or gauge possible price fluctuations of goods in the future.
• In the bond markets, the forward rate refers to the future rate of return based on interest rates and maturities.

spot rate

A spot rate or spot price is the real-time quoted price for immediate settlement of a contract. In the commodity markets, the spot rate represents the current price to buy or sell a commodity, security, or currency.

A spot price is associated with an immediate need for a commodity since the delivery date of the contract is usually within two business days of the trade date. Irrespective of price fluctuations between the billing date and the delivery date, the contract is processed at the agreed spot rate. Buyers and sellers mitigate the risk of price volatility in contracts with a spot rate by forgoing potentially favorable future market conditions.

An example of a shopper who relies on spot prices is a restaurant that needs fresh ingredients for this week’s business. The restaurant has an immediate business need and must pay the current market price in return for the timely delivery of the goods. Alternatively, a local farm may have grown crops that could spoil if not sold within the next week. The local farm relies on the spot rate to sell their produce before the expiration date.

forward rate

What if the restaurant or farmer didn’t have to process the goods immediately? Market participants willing to trade in the future rely on the forward rate.

raw materials

A forward rate is a price agreed by all parties involved for the delivery of a commodity at a specific point in time in the future. The use of forward rates can be speculative when a buyer believes that the future price of a good will be higher than the current forward rate.

Alternatively, sellers use forward rates to mitigate the risk that the future price of a good will fall significantly.

terminology

The difference between the spot and forward rate is called the basis.

Regardless of the prevailing spot rate at the time the forward rate expires, the agreed contract will be executed at the forward rate. For example, on January 1, the spot price for a box of iceberg lettuce is $50. The restaurant and farmer agree to ship 100 boxes of iceberg lettuce on July 1 at an upfront price of $55 per box. Even if the price per case has dropped to $45/case or increased to $65/case on July 1st, the contract will continue at $55/case.

Bind

The forward interest rate on a bond is calculated by comparing the expected future yield of two bonds. The forward interest rate is the yield obtained if the proceeds from the earlier bond are then reinvested to match the life of the later bond.

How do you calculate the forward rate for a bond?

The formula for the one-year forward interest rate for a two-year bond is:

| { [ ( 1 + Raten1 )n1 ÷ ( 1 + Raten2 )n2 ] ÷ [ (Raten1 – Raten2 ) ] } -1 | * 100

Where:

• Rate1 = spot rate for the two-year bond
• Rate2 = spot rate for a one-year bond
• n1 = number of years for the first bond
• n2 = number of years for the second bond

Imagine the spot price for the two-year bond is 3.996% and the interest rate for the one-year bond is 4.790%.

The steps to calculate the forward rate are as follows:

1. Determine the expected future yield on the two-year bond. This is calculated as (1 + .03996)2 = 1.081516802.
2. Determine the expected future yield of the one-year bond. This is calculated as (1 + .04970)1 = 1.0497.
3. Divide the results obtained in steps 1 and 2. In this example, the result is 1.03.
4. Divide the result obtained in step 3 by the difference in the number of periods between the two bonds, and then subtract one from the result. In this example, 1.0303% is divided by 1 (2 years – 1 year) and subtracted by 1. Multiply by 100 to get a percentage, and you get a result of 3.03% for the one-year forward rate.

Special considerations

The terms spot rate and forward rate are used slightly differently in the bond and currency markets. In bond markets, the price of an instrument depends on its yield, which is the return on a bond buyer’s investment as a function of time. When an investor buys a bond that is closer to maturity, the bond’s forward rate is higher than the rate on the front.

For example, consider a $1,000 two-year bond with an interest rate of 10%. If the bond is purchased on the issue date, the expected yield on the bond over the next two years is 10%. If an investor plans to buy the bond a year after issuance, the forward rate or price that the investor should expect to see is $1,100 ($1,000 + the 10% of the first year’s accumulated earnings ). If the investor is lucky enough to buy the bond for less than this price in a year’s time, their expected yield will be higher than the coupon on the front of the bond.

The forward rate of a commodity, security, or currency can be determined using the commodity’s current spot rate, and the spot rate can be determined using the forward rate. This relationship largely reflects the relationship between a discounted present value and a future value. As long as an expected interest rate is known and the time frame has been determined, switching from the spot rate to the forward rate is an exercise in converting a present value into a future value, or vice versa.

What is the US 1 year forward rate?

The 1-year forward rate in the US is the interest rate on one-year government bonds. On March 19, 2023, the rate was 3.74%.

What is a Forward Rate Agreement?

A forward rate agreement is a contractual obligation in which two parties agree on a specific transaction price for delivery on a specific day. The forward rate is likely to deviate from the spot rate because both buyers and sellers are motivated to agree on a fixed price to pay in the future.

What is a spot rate in forex trading?

A spot exchange rate is the current exchange rate between two currencies. It is the price to be paid at this moment.

The conclusion

The forward rate is the rate that a trader is willing to pay for an asset or instrument at a future date. The spot rate is the price a trader or investor is paying to buy an asset or instrument at that point in time.