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

Spot Rate vs. Forward Rate: An Overview

A spot rate is the current market price at which a stock, bond, commodity, or currency can be purchased or sold. A forward rate or forward price is a price set in advance between a buyer and a seller for execution on a future date.

The term originates in the commodities futures markets, where the spot rate is the agreed price for an immediate or “on the spot” transaction.

There are small differences in terminology among markets: In the commodities markets, traders refer to the “forward price” instead of “forward rate” because it is the settlement price (not rate) of a transaction that will take place at a predetermined date.

And, in the 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.

A spot rate in the commodities market indicates an immediate need for a commodity, with a delivery date usually falling 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.

When acting on a spot rate, both the buyer and the seller are giving up the chance of a more favorable price in the future while eliminating the risk of an adverse price movement.

An example of a buyer relying on spot rates is a restaurant produce supplier that needs fresh ingredients for this week’s business. The supplier must pay the current market price to receive the goods on time. On the other side of the transaction, a local farmer may have produce that will go bad if not sold within the next week.

Forward Rate

Both buyers and sellers may choose to plan ahead, eliminating uncertainty by agreeing on a forward rate.

Commodities

A forward rate is a specified price agreed to by a buyer and a seller 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 higher than the current forward rate.

Sellers use forward rates to mitigate the risk that the future price of a good will materially decrease.

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 re-invested to match the term of the bond maturing later.

How to 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, consider 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, the 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.

Explain Like I’m Five

A spot rate is the price you pay for an exchange that occurs immediately, with the buyer immediately paying the seller and receiving the asset being sold. In practice it can take some time for full payment and delivery, but a spot transaction is usually settled within two business days.

A forward rate is a price for a transaction that will happen sometime in the future, allowing both buyers and sellers to reduce the risk of price fluctuations. This is particularly useful for farmers, who need to lock in a good price while they wait for their crops to mature. Merchants also use forward transactions to ensure a good exchange rate for international trade.

The Bottom Line

A spot rate is the price for a transaction that occurs immediately, while a forward rate is the price for a transaction to occur sometime in the future. These are frequently used for sales of commodities and currencies, where traders need to lock in their buyers and suppliers well in advance.

Forward rate has a slightly different meaning for fixed income investments, where it refers to the future yield on a bond.