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

Forward Rate vs. Spot Rate: An Overview

The precise meanings of the terms “forward rate” and “spot rate” are somewhat different in different markets. In general, a spot rate refers to the current price or bond yield, while a forward rate refers to the price or yield for the same product or instrument at some point in the future.

In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or “on the spot”. A forward rate is the settlement price of a transaction that will not take place until a predetermined date.

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 the purchase or sale of a commodity, security, or currency.

A spot rate is associated with the immediate need for a good as the delivery date of the contract normally occurs within two business days of the trade date. Regardless of price fluctuations that occur between the settlement date and the delivery date, the contract will be completed at the agreed-upon spot rate. When contracting with a spot rate, buyers and sellers are mitigating price fluctuation risk 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 immediately transaction for the goods? Market participants that are willing to transact in the future rely on the forward rate.

A forward rate is a specified price agreed 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 at the time 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.

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 purchasing 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 timeframe 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.

This calculation is slightly different for bond markets, as different bonds with varying terms can be compared to determine forward rates. For example, imagine a two-year bond paying 7.5% and a one-year bond paying 6.5%. Subtracting the two-year bond’s future value from the one-year bond’s future value a year from now results in the expected one-year forward rate.