In this article, we will talk about the forward rate calculator. We have created this tool to help you compute the forward rate quickly and easily. Regardless of the term structure and rate, it will provide the result in no time.
Specifically, this handy tool is intended to calculate the investment interest rates between the ends of the two periods. It actually calculates compounded forward rates on an annual basis. That makes it a useful tool for any type of investment.
If you read through this article, you’re going to find out more about the forward rate and learn how it’s calculated. More importantly, you will learn how this works in practice and how it can be applied in bond valuation. It is worth a look!
What Does the Forward Rate Mean?
To understand what the forward rate stands for, you should first have a clear understanding of the interest rate when it comes to investments. As you may already know, the interest rate is defined as the amount of interest charged on a loan.
It is calculated by taking the interest rate and multiplying it by the amount of time that has passed since the last payment. The interest rate can also be referred to as a percentage which is calculated by dividing the yearly interest rate by 100. For example, if an interest rate is 3% then the yearly interest rate would be .03/100 or .3%.
So, what is the forward rate? It’s the interest rate that’s going to be initiated down the line. In order to understand what impact it will have on investment, you need to determine this measure using our calculator. It is also possible to determine forward rates utilizing term structures as well as the respective spot rates.
The forward rate is the rate that a bank charges for borrowing money. These rates are typically quoted in annual percentage rates and are used to calculate the cost of borrowing for a given period. For example, if the bank quotes a forward rate of 1.5% and you borrow $100,000 for one year, your annual interest charge would be $1,500. It’s worth noting that this estimation assumes that arbitrage opportunities do not exist and it only applies to perfectly efficient markets.
Forward Rate Formula: How to Calculate It?
Now that you know more about the forward rate, it’s time to see how it can be calculated. Keep in mind that it can be complicated to calculate the forward rate. To help you understand this concept, we will break it down for you and use an example.
Since these rates are typically used to evaluate the bond values in the future, we will assume that you are interested in investing in the bond market for a certain period of time. Let’s say this period is 8 years. In this case, you will be able to consider two options:
- You can either invest your money right away in an 8-year corporate bond, or
- Make the first investment into a five-year corporate bond today and keep investing your money in a three-year bond later on.
What option is better for you? This is something you need to think about before making up your mind. By choosing the first option, you’ll be able to calculate the yield (it is referred to as the spot rate) on the 8-year investment with ease. It is not difficult to determine.
What if you go for the second option? If you choose this option, the proceeds for your prior 5-year investment will be used as a source of money for the next investment. In this case, the 5-year investment yield is the only thing you know. This means you will have to calculate the forward rate for the first period to have an idea of the 3-year bond yield (for the second period) on the investment that’s going to occur 5 years from now.
When making an investment, you don’t know this yield in advance. This is actually the forward rate on your investment. In our example, it’s the rate for a three-year period that starts five years from now. If you want to calculate this forward rate, you will need to find four inputs, including:
- Time period 1 – As this is the longer investment, make sure it is longer than the second period.
- Time period 2 – It should be a shorter period that continues after the 1st period of investment.
- The interest rate for the 1st period – The rate of investment you make from today till the end of the first period.
- The interest rate for the 2nd period – The rate from today till the end of the second period.
Did you find these inputs? Great! Now you can calculate the forward rate. Here’s the formula you need to use:
Forward Rate = (((1 + Spot rate for time period 1) ^ Time period 1) / ((1 + Spot rate for time period 2) ^ Time period 2)) ^ (1 / (Time period 1 – Time period 2)) – 1
Example
As mentioned above, we will give an example to help you figure out how the forward rate is calculated. The inputs are as follows:
- Time period 1 (years): 5
- The spot rate for the first period: 6.00%
- Time period 2 (years): 3
- The spot rate for the second period: 3.00%
Okay, now that we have all the necessary inputs, we are able to determine the forward rate using the aforementioned formula. Take a look below to see what the calculation looks like. We will explain it step by step.
Forward Rate = (((1 + 0.06) ^ 5) / ((1 + 0.03) ^ 3)) ^ (1 / (5 – 3)) – 1
Forward Rate = ((1.06) ^ 5) / ((1.03 ^ 3)) ^ (1 / 2) – 1
Forward Rate = ((1.06) ^ 5) / ((1.03 ^ 3)) ^ (1 / 2) – 1
Forward Rate = (1.34 / 1.09) ^ 0.5 – 1
Forward Rate = 0.1066
So, the forward rate is 10.66% in our example. Use your own inputs and play with different numbers to see how it works in practice. If you want to save time, use our calculator to get the result in a matter of seconds. It is easy to use!