1. What is the One Year Forward Rate Formula?

Definition: This formula calculates the implied one-year interest rate for a period one year from now, derived from current one-year and two-year interest rates.

Purpose: It helps investors and financial analysts understand market expectations of future interest rates and make informed investment decisions.

2. How Does the Formula Work?

The formula is:

Where:

• \( f \) — One year forward rate (decimal)
• \( r_1 \) — Current 1-year spot rate (decimal)
• \( r_2 \) — Current 2-year spot rate (decimal)

Explanation: The formula equalizes the returns from two investment strategies: (1) investing for two years at the 2-year rate, and (2) investing for one year at the 1-year rate and then reinvesting for another year at the forward rate.

3. Importance of Forward Rate Calculation

Details: Forward rates are essential for bond valuation, interest rate derivatives pricing, and understanding market expectations about future interest rate movements.

4. Using the Calculator

Tips: Enter the current 1-year and 2-year spot rates as decimals (e.g., 0.05 for 5%). The calculator will compute the implied one-year rate one year from now.

5. Frequently Asked Questions (FAQ)

Q1: What does the forward rate represent?
A: It represents the market's expectation of the one-year interest rate that will prevail one year from now.

Q2: How is this different from the spot rate?
A: Spot rates are current market rates, while forward rates are implied future rates derived from current spot rates.

Q3: What if the yield curve is flat?
A: If r₁ = r₂, then the forward rate f will equal the spot rates, indicating no expected change in interest rates.

Q4: Can this be used for longer time periods?
A: Yes, similar formulas exist for forward rates further in the future using longer-term spot rates.

Q5: How accurate are forward rates as predictors?
A: While they reflect market expectations, actual future rates may differ due to unforeseen economic changes.