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, expected short-term real return, and expected inflation. Graphing forward rates produces a forward curve, which assesses the time value of money and market strength. However, historical data shows that forward rates reflect market sentiment at the time and are not a reliable predictor of future spot rates.
Forward interest rates are a type of interest rate found on financial instruments that begin at a future date with a specified maturity date. Financial instruments with forward interest rates are popularly used to hedge possible 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 argue that there is no relationship between these two rates. A spot rate is the current interest rate for contracts that start immediately.
Hedging against potential interest rate risk is the most popular use of financial instruments that include forward interest rates. Hedging offsets an individual’s position by offsetting the opposite position to eliminate or reduce the effects of changes. The seller of the forward contract wants to be protected against possible interest rate decreases, while the buyer seeks protection against the possibility of an interest rate increase. When the contract expires, the only money that exchanges hands is the difference between the market rate and the forward rate.
The forward interest rate calculation includes a liquidity premium, the expected short-term real return, and expected inflation. The liquidity premium is assumed to increase at a decreasing rate as maturity progresses, with the forward rate increasing the longer the financial instrument takes to mature. If short-term real returns and inflation are expected to remain constant, forward rates should have the same form as the liquidity premium for the period.
Graphing interest rates forward produces a forward curve. This curve is used to assess the time value of money, or how much a dollar will be worth today at a specific point in the future. Since the current 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. Charting future interest rates also allows analysts to determine the strength or weakness of the market by looking at the shape of the curve.
Studies of historical forward interest rate data reveal that forward interest rates reflect evolving market sentiment at that time, not rates that are likely to be in the future. Since future interest rates are constantly changing based on current market sentiment, it is not a good predictor of what spot rates will be in the future. However, some investors argue that it provides them with enough information to be useful in forecasting.
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