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Forward interest rates are a type of interest rate found on financial instruments that commence on a future date with a specified maturity date. Financial instruments with forward interest rates are popularly used for hedging against potential interest rate changes. These rates are commonly found on loans, bonds and options. While some investors use forward interest rates to predict future spot rates, many analysts dispute that there is no relationship between these two rates. A spot rate is the current interest rate for contracts beginning immediately.
Hedging against potential interest rate risk is the most popular use of financial instruments that include forward interest rates. The hedge compensates for an individual's position by offsetting it with the opposite position to eliminate or reduce the effects of changes. The seller of the forward contract wants to be protected against potential interest rate declines, while the buyer is searching for protection against the possibility that interest rate will increase. When the contract matures, the only money that exchanges hands is the difference between the market rate and the forward interest rate.
Calculation of the forward interest rate includes a liquidity premium, expected short-term real return and expected inflation. The liquidity premium is assumed to increase at a decreasing rate as maturity progresses, increasing the forward interest rate the longer it takes for the financial instrument to mature. If short-term real returns and inflation are expected to remain constant, forward rates should have the same shape as the liquidity premium for the period.
Graphing forward interest rates produces a forward curve. This curve is used to evaluate the time value of money, or how much a dollar today will be worth at a specific point in the future. Since the present value of a dollar today is generally less than its future value, the forward interest rate must be high enough to cover inflation and allow the investor to be compensated for any perceived risk. Graphing forward interest rates also allows analysts to determine the strength or weakness of the market by looking at the shape of the curve.
Studies of historical forward interest rate data reveal that forward interest rates reflect evolving market sentiment of that time, not what rates will likely be in the future. Since forward interest rates are constantly changing based on current market sentiment, it is not a good predictor of what spot rates will be in the future. Some investors argue, however, that it does provide them with enough information to be useful in forecasting.
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