Forward Rate vs. Spot Rate: What's the Difference?

Forward Rate vs. Spot Rate: An Overview

A spot rate is the current price at which a commodity, currency, or security can be purchased. A forward rate is the future price a currency trader agrees to or the yield on a bond on a future date.

In commodities futures markets, the spot rate is the price for a commodity being traded immediately or "on the spot." One key difference between the two terms in the commodities markets is that traders use "forward price" instead of "forward rate" because it is the settlement price of a transaction that will not take place until a predetermined date—not a rate.

In bond markets, the forward rate refers to the effective yield on a bond, commonly U.S. Treasury bills, and is calculated based on the relationship between interest rates and maturities.

Spot Rate

A spot rate or spot price is the real-time price quoted for the instant settlement of a contract. In commodities markets, the spot rate represents the current price for purchasing or selling a commodity, security, or currency.

A spot rate is associated with the immediate need for a good, as the contract's delivery date typically occurs within two business days of the trade date. Regardless of price fluctuations between the settlement and delivery dates, the contract will be completed at the agreed-upon spot rate. Buyers and sellers mitigate price fluctuation risk when contracting with a spot rate by sacrificing potentially favorable future market conditions.

An example of a buyer relying on spot rates is a restaurant that needs fresh ingredients for this week's business. The restaurant has an immediate business need and must pay the current market price in exchange for the goods to be delivered on time. Alternatively, a local farm may have cultivated crops that may go bad if not sold within the next week. The local farm relies on the spot rate to sell their product before the goods expire.

Forward Rate

What if the restaurant or farmer didn't need to transact for the goods immediately? Market participants that are willing to transact in the future rely on the forward rate.

Commodities

A forward rate is a specified price agreed on by all parties involved for the delivery of a good at a specific date in the future. The use of forward rates can be speculative if a buyer believes the future price of a good will be greater than the current forward rate.

Alternatively, sellers use forward rates to mitigate the risk that the future price of a good materially decreases.

Regardless of the prevailing spot rate when the forward rate meets maturity, the agreed-upon contract is executed at the forward rate. For example, on January 1st, the spot rate of a case of iceberg lettuce is $50. The restaurant and the farmer agree to the delivery of 100 cases of iceberg lettuce on July 1st at a forward rate of $55 per case. On July 1st, even if the price per case has decreased to $45/case or increased to $65/case, the contract will proceed at $55/case.

Bonds

The forward rate for a bond is calculated by comparing the future expected yield of two bonds. The forward rate is the yield that will be earned if proceeds from the bond maturing earlier are then re-invested to match the term of the bond maturing later.

How Do You Calculate the Forward Rate for a Bond?

The formula for the one-year forward rate for a two-year bond is:

| { [ ( 1 + Rate_n1 )ⁿ¹ ÷ ( 1 + Rate_n2 )ⁿ² ] ÷ [ (Rate_n1 - Rate_n2 ) ] } -1 | * 100

Where:

• Rate_n1 = Spot rate for the two-year bond
• Rate_n2 = Spot rate for one-year bond
• n1 = Number of years for the first bond
• n2 = Number of years for the second bond

Imagine the spot price for the two-year bond is 3.996%, and the one-year bond rate is 4.790%

The steps to calculate the forward rate are as follows:

1. Determine the expected future return of the two-year bond. This is calculated as (1 + .03996)² = 1.081516802.
2. Determine the expected future return of the one-year bond. This is calculated as (1 + .04970)¹ = 1.0497.
3. Divide the results obtained in steps 1 and 2. In this example, the result is 1.03.
4. Divide the result obtained in step 3 by the difference in the number of periods between the two bonds, then subtract one from the result. In this example, 1.0303% is divided by 1 (2 years - 1 year), and one is subtracted. Multiply by 100 to get a percent, and you get a result of 3.03% for the one-year forward rate.

Special Considerations

The terms spot rate and forward rate are applied a little differently in bond and currency markets. In bond markets, the price of an instrument depends on its yield—that is, the return on a bond buyer's investment as a function of time. If an investor buys a bond that is nearer to maturity, the forward rate on the bond will be higher than the interest rate on its face.

For example, imagine a $1,000 two-year bond with a 10% interest rate. If the bond is purchased on the issuance date, the expected yield on the bond over the next two years is 10%. If an investor plans on buying the bond one year from issuance, the forward rate or price the investor should expect to pay is $1,100 ($1,000 + the 10% accumulated earnings generated from the first year). If the investor is lucky enough to purchase the bond in a year for less than this price, their expected yield will be greater than the coupon rate on the face of the bond.

The forward rate of a commodity, security, or currency can be determined using the current spot rate of the good, and the spot rate can be determined using the forward rate. This relationship closely mirrors the relationship between a discounted present value and a future value. As long as an expected yield rate is known and the time frame has been determined, the change from spot rate to forward rate is an exercise of converting a present value to a future value or vice versa.

The Bottom Line

The forward rate is the rate a trader agrees to pay for an investment or instrument on a future date. The spot rate is the price a trader or investor pays at that moment to purchase an asset or instrument.