Forward rate and spot rate are two terms used to describe different aspects of interest rates. These are common in various markets. However, they have different meanings according to the market where they are prevalent. These are most common in bond markets but may also apply to other contracts or instruments. The differences between forward and spot rates are as below.
What is Forward Rate?
The forward rate represents the expected values of future financial transactions that investors can expect to occur in the future. Therefore, forward rates apply to all financial transactions with a value or maturity in the future. Investors can use the spot rate to calculate an instrument or option's forward rate. In some markets, the forward rate may also refer to the predetermined or fixed rate for financial obligations.
A forward interest rate shows the coupon rate on a bond or interest rate on a loan that will commence sometime in the future. Therefore, the forward interest rate represents the rate that will apply to a transaction in the future. Forward rates are crucial in bond markets. When investors buy a bond in the market, they consider its forward and spot rate.
The price of a bond or instrument depends on its future returns. When buying a bond nearing its maturity, the bond's forward rate will be higher than its interest rate. The difference between spot and forward rate may be significant. Investors can use various models or approaches towards calculating the forward rate.
What is Spot Rate?
The spot interest rate represents the price of a financial instrument on a spot date. The spot date refers to the day when investors pay funds for the transfer of the financial instrument. It may be on the same day as participants complete the transaction. Usually, however, it is two days after the trade. Usually, the spot rate represents the current market rate of security for immediate settlement.
A contract or instrument’s spot rate may vary over time and based on the market. However, the prices stay similar across various markets. This way, there is no room for arbitrage exploitation due to price disparities. The spot rate also plays a significant role in the calculation of the forward rate. Based on the spot rate, investors can estimate the fluctuations in future commodity prices.
Investors use a spot rate when looking to make immediate purchases or sales. However, they use the forward rate to develop expectations for future prices. Investors can use it as an economic indicator of how they expect the future to perform. However, spot rates do not indicate market expectations or future prices.
What are the differences between Forward and Spot Rate?
As mentioned, the meaning of forward and spot rates may differ across various markets. With bonds, the forward rate represents the effective yield on a bond or US Treasury bills. In contrast, the spot rate refers to the price of a financial contract on the spot date. As mentioned, the spot date may be on the same day as the transaction, but it normally occurs within two days after a trade.
Conclusion
There are two terms commonly associated with bonds. These include spot and forward interest rates. The meaning for these may differ based on the market they are used. However, forward rates usually indicate the effective yield on a bond. The spot rate, in contrast, shows the expected price of a bond on the spot date, which is usually two days after the trade.
Originally Published Here: Forward Rate vs Spot Rate
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