Forward interest rates are used to hedge against potential changes in interest rates on financial instruments such as loans, bonds, and options. The calculation includes a liquidity premium, short-term real yield, and expected inflation. Graphing forward interest rates produces a forward curve, which is used to evaluate the time value of money. Historical data shows that forward interest rates reflect market sentiment, not future rates.
Forward interest rates are a type of interest rate found on financial instruments that start on a future date with a specified expiration date. Financial instruments with forward interest rates are commonly used to hedge against potential changes in interest rates. These rates are commonly found on loans, bonds and options. While some investors use forward interest rates to predict future spot rates, many analysts dispute that there is no relationship between these two rates. A spot rate is the going interest rate for contracts that start immediately.
Hedging against potential interest rate risk is the most common use of financial instruments that include forward interest rates. The hedge compensates for one individual’s position by offsetting it with the opposite position to eliminate or reduce the effects of changes. The seller of the forward contract wants to be protected against potential falls in interest rates, while the buyer seeks protection against the possibility of the interest rate rising. When the contract expires, the only money that changes hands is the difference between the market rate and the forward interest rate.
The calculation of the forward interest rate includes a liquidity premium, the expected short-term real yield and expected inflation. The liquidity premium is assumed to increase at a decreasing rate as maturity progresses, increasing the forward interest rate the longer the financial instrument takes to mature. If short-term real yields and inflation are expected to remain constant, forward rates should have the same form as the liquidity premium for the period.
Graphing forward interest rates produces a forward curve. This curve is used to evaluate the time value of money, or how much a dollar will be worth today at a specific point in the future. Since the present value of a dollar today is generally less than its future value, the forward interest rate must be high enough to cover inflation and allow the investor to be compensated for any perceived risk. The graphical representation of forward interest rates also allows analysts to determine the strength or weakness of the market by observing the shape of the curve.
Studies of historical data on forward interest rates reveal that forward interest rates reflect how market sentiment evolved over that period, not what rates are likely to look like in the future. Because forward interest rates are constantly changing based on current market sentiment, it’s not a good predictor of what spot rates will be in the future. Some investors argue, however, that it gives them enough information to be useful in forecasting.
Smart Asset.
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