In relation to bonds, forward rate denotes the future yield on a bond (e.g., T-bond, T-note or T-bill). Simply put, it is the interest rate expected now to be prevailing at a future date. This rate is inferred using the yield curve (yield to maturity against maturity) or less often based on spot rates (the yield-to-maturity on a zero-coupon bond) in which case the rate is called an implied forward rate (forward yield). For example, forward rate may be calculated as the yield on a 2-year Treasury note one year from present time. Using the yield curve to calculate forward rate may depending on one of three distinct rates: simple rate, annually compounded rate, and continuously compounded rate.
Alternatively, though less practically, forward rates can inferred from spot rates, by converting the spot rate to the forward rate:
F = ((1 + S1)^T1 / (1 + S2)^T2) – 1
Where: F is forward rate, S1 is spot rate for the bond of term T1 period, and S2 is spot rate for the bond of T2 period.
For example, suppose that a 4-year bond has a yield of 10%, while a two-year bond is yielding 5.5%. The forward rate can be calculated as follows:
F = ((1 + 0.10)^4 / (1 + 0.055)^2 – 1 = 0.1577 = 15.77%
The resulting figure, 15.77% is the hypothetical forward rate that a bondholder is expected to receive from the bond in the future.
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