Business Case Studies & Business Publications

Spot and Forward Interest Rates

Tomio, Davide

Technical Note

Spot and Forward Interest Rates

Tomio, Davide

F-2084 | Published August 8, 2024 | 6 pages Technical Note

Collection: Darden School of Business

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Product Details

Interest rates come in many varieties. The most common interest rates apply from today to some future date and are referred to as spot rates. But what if you agreed to lend money to someone at a 6% rate for six months starting in one year? That rate would be called a forward rate. Forward rates are agreed upon today for transactions that start and end at a future date, with related payments occurring in the future. As time passes, market spot rates may be above or below the contracted forward rate, but the contract that established the forward rate obligates both parties to honor the agreed-upon rate. In other words, the forward rate is the term of a contractual commitment signed today. While the interest rates we most often encounter are spot rates (the interest rates we pay on mortgages, credit cards, etc.), forward-rate contracts can be extremely valuable in a host of financial settings. This note addresses how spot and forward interest rates relate to bond prices and to each other. The basis of the relation between spot rates and forward rates is the law of one price—the condition in markets when prices are such that arbitrageurs cannot profit by exploiting price differentials across spot and forward rates. Market activity enforces a very specific mathematical relation between spot and forward rates.