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The Importance of Forward Rates

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By Emily Hollis, CFA

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A forward rate is a rate applicable to a financial transaction that will take place in the future. Forward rates are the basis of the term structure of interest rates.

In the context of bonds, forward rates are calculated to determine future values. For example, an investor can purchase a two-year bullet security or a one-year bullet security and roll it into another one-year bullet security once it matures. The investor will be indifferent if they both produce the same result. The investor will know the spot rate[1] for the one-year security and the two-year security, but he or she will not know the value of a one-year security that is purchased one year from now. Yet, given these two rates, the forward rate on a one-year security will be the rate that equalizes the dollar return between the two types of investments. In other words, in a world of certainty, equilibrium forward rates must coincide with future spot rates; however, it’s when uncertainty about future rates is introduced that opportunities arise.

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