What is forward rate

Hey guys, it's William Jiamin here. In this video, I'm going to share with you the concept of forward rates. So, let's use an example to better understand it.

Imagine a timeline with two points, M and M + N, representing a certain time period. Let's say N represents the maturity of a bond, which could be any number of years. During this period, we want to analyze the interest rate on the bond.

If the bond has a coupon rate of 5%, it means that the bond holder will receive a 5% coupon payment. However, if it's a zero coupon bond, the bond holder will only benefit from the change in price. For example, if the face value of the bond is 1 unit at the end of time M + N, the bond holder can benefit from the discounted price appreciation.

To calculate the forward rate, we need to discount the 1 unit back to time M. We use the formula (1 + analyzed interest rate) to discount it, denoted as F starting at time M and ending at time M + N. The forward price represents the future value of 1 unit at time M + N, discounted at the analyzed interest rate.

It's important to remember that we're discussing forward rates here. The analyzed interest rate is the annualized rate on a 1 unit loan, initialized at time M and ending at time M + N. This is also known as the forward rate.

Additionally, just like the term structure of spot rates, forward rates also have a term structure known as the forward curve. There are mathematical connections between the forward curve and the spot curve, allowing us to infer one from the other. By analyzing the changes between these curves, we can solve problems and make informed decisions.

We'll delve deeper into these concepts in future discussions. For now, remember that forward rates represent the analyzed interest rates on specific loans or bonds.