Forward rate is a predicted interest rate of the future.
Forward rate is a term used in finance. It relates to interest rate because these two rates are needed to calculate the price of a future engagement which, in finance, is known as a "forward contract." Calculating forward rate is most used in hedging, a financial activity to minimize foreign exchange rate risks.
Definition of Forward Rate
Forward rate is a rate used to calculate the purchase price of a currency, commodity or priced assets at a specific date and time in the future.
Definition of Interest Rate
Interest rate is either an expense of consumption or revenue of investment on a money activity. For example, it is an expense of consumption when one borrows money from a financial institute and is being asked to return the money borrowed with interest, a percentage of the money borrowed in a future time. It is a revenue of investment when one loans out money and receives interest plus the principal sum in the future as compensation. Interest rate is affected by the economic conditions of a country. For instance, the Federal Reserve in the United States affects interest rates through the country's monetary policy.
Relationship Between Interest Rate and Forward Rate
The most common use of interest rate and forward rate is in hedging, a financial activity to minimize foreign exchange rate risks. Hedging is performed through a financial instrument, currency swap. When you exchange currency between countries, there are differences in monetary value that may lead to a loss of value of one currency when it is exchanged into another currency. This is known as exchange rate risk. In an effort to reduce the risk associated with differences in monetary value, you enter into a hedge where you offset the risk through exchanging a "spot" contract (that uses the interest rate of today) with a "forward" contract (that uses the forward rate of a certain future time) of equal amount.
How Forward Rate is Determined
Suppose you know that if you exchange currency A into currency B today, you could gain interest of 6 percent annually by depositing the money into a CD for currency B. Under a certain contract with your business partner, you could not exchange the currency until one year from today. Because your risk-free interest rate from the CD is 6 percent, your contract with your business partner is only worthwhile if your partner is willing to pay a forward rate of 6 percent. That is a total sum of currency B plus 6 percent of currency B.
The Relationship in the Simplest Term
The relationship between forward rate and interest rate in the simplest terms is "forward rate" is a predicted "interest rate" of the future.
