forwardrate

Forward rate is a term used in finance to denote an interest rate agreed upon today for a loan or investment that will commence at a specified future date. The concept appears in two related contexts: forward rate agreements (FRAs) and the instantaneous forward rates implied by a term structure of interest rates or zero-coupon yields.

In the context of FRAs, a forward rate contract sets the rate at which a borrower and lender will settle a loan starting at a future date for a defined period. The contract fixes the rate and notional amount now, while settlement occurs at the beginning of the forward period. The payoff is the net interest difference between the contracted rate and the realized rate, discounted to the settlement date.

Forward rates derived from the term structure reflect market expectations of future interest rates implied by current prices of bonds or zero-coupon instruments. If P(t,T) denotes the price today of a zero-coupon payment at time T, the forward rate for the period from T1 to T2 can be expressed (under simple compounding) as f(t; T1, T2) = [(1+P(t,T2)) / (1+P(t,T1))]^(1/(T2−T1)) − 1. More generally, continuous compounding allows a related formula. These forward rates are model-free in principle and depend on the observed yield curve, not on a specific forecast of future short rates.

Applications include pricing and hedging interest rate derivatives, constructing forward rate curves, and guiding risk management in fixed income portfolios. In foreign exchange markets, the term forward rate also refers to the agreed-upon exchange rate for a currency pair at a future date, determined by interest rate parity.