Implied forward rates from spot rates
Investing for B years at the B-year spot rate must give the same result as investing for A years and then locking in a rate for the remaining B − A years. That locked-in rate is the implied forward rate: (1 + z_A)^A (1 + IFR)^(B−A) = (1 + z_B)^B.
Before this: Term Structure: Spot, Par and Forward Curves, Time Value of Money in Finance
On the exam
- Explain how forward rates are determined for interest rate forward contracts and describe the uses of these forward rates
Explain how forward rates are determined from spot rates. Expect a 1y1y or 2y1y forward computed from two spot rates, a discount factor, the meaning of a label such as 1y4y, and a sub-year version with periodic rates.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What are spot rates and discount factors?
Interest rates have a term structure: different maturities carry different rates. The spot rate for maturity i, z_i, is the yield on a single cash flow paid at time i. Because it prices a bond with no coupons, it is also called the zero rate . For a one-period instrument the yield to maturity and the zero rate are the same.
The price equivalent of a zero rate is the discount factor : the present value of one currency unit paid at time i.
Our curve for this lesson: z₁ = 2.7%, z₂ = 3.3%, z₃ = 3.8%. That gives DF₁ = 0.9737, DF₂ = 0.9371 and DF₃ = 0.8941.
The 2-year spot rate is 3.30%. The 2-year discount factor is closest to:
1 ÷ (1 + 0.033)^2 = 0.9371
Discount factor, DF_i0.9371
- 1.033y^x2=1/x0.937129
y^x power · 1/x reciprocal
- 1.033ENTER2y^x1/x0.937129
ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal
Where do spot rates come from?
Know the idea
Most traded bonds pay coupons, so spot rates are extracted from them one maturity at a time. This is called bootstrapping . The one-year bond has a single cash flow, so its yield is z₁. Substitute z₁ into the two-year bond’s price equation and solve for z₂.
What is an implied forward rate?
The implied forward rate is the breakeven reinvestment rate that links a shorter and a longer spot rate. Take two ways to invest for B years:
- invest today to the longer maturity B at the spot rate z_B, or
- invest to the shorter maturity A at z_A and then reinvest for the remaining B − A years at a rate locked in today.
The no-arbitrage condition for rates says both routes must end with the same money. If they did not, a trader could borrow on one route and lend on the other. The locked-in rate that makes them equal is the forward rate.
The label tells you the period: the first number is when it starts, the second is how long it runs.
- 1y1y Memorize one-year rate starting in one year; ends at year 2
- 2y1y Memorize one-year rate starting in two years; ends at year 3
- 1y2y Memorize two-year rate starting in one year; ends at year 3
- 2y5y Memorize five-year rate starting in two years; ends at year 7
The 2-year spot rate is 3.30% and the 3-year spot rate is 3.80%, both annually compounded. The implied forward rate for the 1-year period starting in 2 years is closest to:
(1.038^3 ÷ 1.033^2)^(1 ÷ 1) − 1 = 4.81%
Implied forward rate, IFR (A to B)4.81%
- (1.038y^x3)÷(1.033y^x2)=1.048073
- −1=0.048073
y^x power
- 1.038ENTER3y^x1.033ENTER2y^x÷1.048073
- 1−0.048073
ENTER enter (on the HP, puts the number on the stack) · y^x power
Try this 0 of 3
- Flatten the curve until the forward steps sit on the spot line
- Make 1y1y lower than the 1-year spot rate
- Pick 2y1y and raise z₃ by 0.30 (to 4.10% in the worked example)
Drag the spot points (or type them), then pick which forward to read.
- Spot rate
- One-year forward
- 1y1y: 1 year, starting in 1 year
Spot rates 2.70%, 3.30%, 3.80% at 1, 2 and 3 years imply one-year forward rates 2.70%, 3.90%, 4.81% for years 1, 2 and 3. 1y1y is 3.90%.
USD 100 two ways (interest earned)
- Interest at the 2-year spot rate
- Interest in year 1
- Interest at the forward 1y1y
| Maturity | Spot z | Discount factor |
|---|---|---|
| 1 year | 2.70% | 0.9737 |
| 2 years | 3.30% | 0.9371 |
| 3 years | 3.80% | 0.8941 |
Both routes end at USD 106.71, so neither beats the other. 1y1y is above the 2-year spot rate because spot rates rise over this stretch.
Show working
No arbitrage: (1 + z₁) × (1 + 1y1y) = (1 + z₂)².
1y1y = [(1 + 3.30%)² ÷ (1 + 2.70%)] − 1 = (1.067089 ÷ 1.027000) − 1 = 3.904%, about 3.90%.
Same thing with discount factors: (DF₁ ÷ DF₂) − 1 = (0.973710 ÷ 0.937129) − 1 = 3.904%.
Shortcut: (2 × 3.30% − 1 × 2.70%) ÷ 1 = 3.900%. Close here, but it ignores compounding and drifts further off as rates and gaps grow, so use the formula.
- 1.033x²÷1.027=(1 + z₂)² ÷ (1 + z₁)
- −1=0.039035
x² square
- 1.033ENTER×1.027÷(1 + z₂)² ÷ (1 + z₁)
- 1−0.039035
ENTER enter (on the HP, puts the number on the stack)
Display: 0.039035 = 3.90%
Each forward is higher than the spot rates on either side because the spot curve slopes upward. Flatten the curve and the forwards collapse onto the spot rates.
- Discount factor, DF_i Memorize the price equivalent: what 1 paid at time i is worth today
- Implied forward rate Memorize the breakeven reinvestment rate linking a shorter and a longer zero rate
- Forward rate agreement (FRA) a contract that fixes the rate for one forward period at the implied forward rate
- Swap rate built from a strip of forward rates (swap pricing module)
-
Exam tip Do not average. 2 × 3.3% − 2.7% = 3.9% looks right here, but it breaks down with longer gaps and more decimals. Use the compounding equation.
How do I handle periods shorter than a year?
Market reference rates are quoted for months, not years. Convert every rate to the same periodicity first, then apply the same equation to the periodic rates, and annualize at the end.
What are forward rates used for?
The implied forward rate is the no-arbitrage fixed rate for a forward rate agreement, the subject of the next lesson. It also prices each period of a swap. The same method works for any underlying with a term structure, such as credit spreads or implied volatility, but the exam concentrates on interest rates.
Go deeper Why forward rates are not forecasts
An implied forward rate is a breakeven rate, not a prediction of where spot rates will be. It is what you can lock in today. If investors demand extra yield for holding longer bonds, forward rates tend, on average, to sit above the spot rates that actually turn up later.
Memorize this
MemorizeForward-rate labels and the equation behind each
| Label | Starts in | Runs for | Equation |
|---|---|---|---|
| 1y1y | 1 year | 1 year | |
| 2y1y | 2 years | 1 year | |
| 1y2y | 1 year | 2 years |
Memory hook Left number = when it starts; right number = how long it lasts. Start plus length is the maturity of the longer spot rate: both routes must end with the same money.
Know it cold . . Upward-sloping spot curve means forwards above spot rates. Never average the spot rates.
- Discount factor, DF_i Memorize the price equivalent: what 1 paid at time i is worth today
- Implied forward rate Memorize the breakeven reinvestment rate linking a shorter and a longer zero rate
- Forward rate agreement (FRA) a contract that fixes the rate for one forward period at the implied forward rate
- Swap rate built from a strip of forward rates (swap pricing module)
-
- 1y1y Memorize one-year rate starting in one year; ends at year 2
- 2y1y Memorize one-year rate starting in two years; ends at year 3
- 1y2y Memorize two-year rate starting in one year; ends at year 3
- 2y5y Memorize five-year rate starting in two years; ends at year 7
Quick example
The three-year spot rate is 4.5%. DF₃ = 1 ÷ 1.045³ = 0.8763. One currency unit paid in three years is worth 0.8763 today.
- 1.045y^x3=1/x 0.8763
y^x power · 1/x reciprocal
- 1.045ENTER3y^x1/x 0.8763
ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal
Quick example
z₂ = 2.0% and z₃ = 2.6%. The 2y1y rate satisfies 1.02² × (1 + IFR) = 1.026³, so IFR = 1.026³ ÷ 1.02² − 1 = 3.81%.
- (1.026y^x3)÷(1.02y^x2)=−1= 0.0381
y^x power
- 1.026ENTER3y^x1.02ENTER2y^x÷1− 0.0381
ENTER enter (on the HP, puts the number on the stack) · y^x power
Quick example
z₁ = 2.0% and z₃ = 3.3%. The 1y2y rate is (1.033³ ÷ 1.02)^½ − 1 = 3.96% a year for the two years starting in one year.
- 1.033y^x3=÷1.02= 1.0807
- y^x21/x=−1= 0.0396
y^x power · 1/x reciprocal
- 1.033ENTER3y^x1.02÷ 1.0807
- 21/xy^x1− 0.0396
ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal
Quick example
A 2.40% rate compounded semiannually, restated with quarterly compounding: 4 × (1.012^0.5 − 1) = 2.39%.
- 1.012y^x0.5=−1=×4= 0.0239
y^x power
- 1.012ENTER0.5y^x1−4× 0.0239
ENTER enter (on the HP, puts the number on the stack) · y^x power
How it is asked
-
One-year forward one year ahead
z₁ = 1.6%, z₂ = 2.9%. 1y1y?
1.029² ÷ 1.016 − 1 = 4.22%. Traps: 2.25% (average), 1.28% (second year left uncompounded).
-
Multi-year forward
z₁ = 2.0%, z₃ = 3.3%. 1y2y?
(1.033³ ÷ 1.02)^½ − 1 = 3.96%. Traps: 8.07% (forgot the root), 2.65% (average).
-
Discount factor
z₂ = 3.3%. DF₂?
1 ÷ 1.033² = 0.9371. Traps: 0.9670 (1 − z), 0.9681 (one year only).
-
Sub-year forward
Six-month rate 2.8%, nine-month rate 3.4% (quarterly compounding). Rate for the 3 months starting in 6?
1.0085³ ÷ 1.007² − 1 = 1.15% a quarter, × 4 = 4.60%. Trap: forgetting to annualize.
Exam traps
- Averaging spot rates. The forward rate comes from the compounding equation, not from an arithmetic mean.
- Forgetting the root for a multi-year forward. For a B − A year period, take the (B − A)th root.
- Mixing annual and periodic rates for sub-year periods. Divide the quoted rate by the periods per year, and annualize the answer.
- Using 2 × z₂ − z₁ as a formula. It is close here but fails with longer gaps and more decimals.
- Reading 1y4y as a one-year rate starting in four years, or as a rate ending in year 4. The first number is the start, the second is the length.
Checkpoint
7 exam-style questions. About 90 seconds each.
1The one-year spot rate is 2.5% and the two-year spot rate is 3.5%, both annually compounded. The one-year rate one year from now (1y1y) is closest to:
2If the two-year spot rate is 3.6%, the two-year discount factor is closest to:
3When the spot curve slopes upward, implied forward rates are most likely:
4A pension fund will reinvest a bond redemption in one year and asks its dealer for the 1y4y forward rate. That rate is best described as the:
5The one-year spot rate is 2.4% and the three-year spot rate is 3.2%, both annually compounded. The annual forward rate for the two years starting in one year (1y2y) is closest to:
6The six-month rate is 4.0% and the nine-month rate is 4.4%, both annualized with quarterly compounding. The annualized implied forward rate for the three months starting in six months is closest to:
7The one-year zero rate is 3.0%. A two-year annual-coupon bond with a 4.0% coupon trades at par (100). The two-year zero rate is closest to:
Key takeaways
- (1 + z_A)^A (1 + IFR)^(B−A) = (1 + z_B)^B: waiting and locking in must equal the longer spot rate.
- DF_i = 1 ÷ (1 + z_i)^i is the price today of one unit paid at time i.
- An upward-sloping spot curve gives implied forward rates above the spot rates.
- For periods shorter than a year, work in periodic rates and annualize the result.
Quick example
The three-year spot rate is 4.5%. DF₃ = 1 ÷ 1.045³ = 0.8763. One currency unit paid in three years is worth 0.8763 today.
- 1.045y^x3=1/x 0.8763
y^x power · 1/x reciprocal
- 1.045ENTER3y^x1/x 0.8763
ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal
Quick example
z₂ = 2.0% and z₃ = 2.6%. The 2y1y rate satisfies 1.02² × (1 + IFR) = 1.026³, so IFR = 1.026³ ÷ 1.02² − 1 = 3.81%.
- (1.026y^x3)÷(1.02y^x2)=−1= 0.0381
y^x power
- 1.026ENTER3y^x1.02ENTER2y^x÷1− 0.0381
ENTER enter (on the HP, puts the number on the stack) · y^x power
Quick example
z₁ = 2.0% and z₃ = 3.3%. The 1y2y rate is (1.033³ ÷ 1.02)^½ − 1 = 3.96% a year for the two years starting in one year.
- 1.033y^x3=÷1.02= 1.0807
- y^x21/x=−1= 0.0396
y^x power · 1/x reciprocal
- 1.033ENTER3y^x1.02÷ 1.0807
- 21/xy^x1− 0.0396
ENTER enter (on the HP, puts the number on the stack) · y^x power · 1/x reciprocal
Quick example
A 2.40% rate compounded semiannually, restated with quarterly compounding: 4 × (1.012^0.5 − 1) = 2.39%.
- 1.012y^x0.5=−1=×4= 0.0239
y^x power
- 1.012ENTER0.5y^x1−4× 0.0239
ENTER enter (on the HP, puts the number on the stack) · y^x power
All Derivatives formulas, every lesson
Practice exam-style questions on Pricing and Valuing Forward Contracts and FRAs
Questions about this lesson?
Where this comes back
- Forward rate agreements (FRAs): settlement and uses Pricing and Valuing Forward Contracts and FRAs
- Pricing and Valuing Interest Rate Swaps Derivatives
- Term Structure: Spot, Par and Forward Curves Fixed Income
Questions candidates ask
How do you calculate an implied forward rate?
Set the two routes equal. Investing to the longer maturity B at z_B must match investing to A at z_A and then earning the forward rate for B − A years. Solve (1 + z_A)^A (1 + IFR)^(B−A) = (1 + z_B)^B for IFR. For a one-year forward, divide the two compounded growth factors and subtract 1.
What is a 1y1y forward rate?
It is the one-year rate that starts one year from now. The first 1y is the start, the second is the length. With z₁ = 2.7% and z₂ = 3.3%, it is 1.033² ÷ 1.027 − 1 = 3.90%.
What is a discount factor?
The present value of one unit of currency paid at a future date: DF_i = 1 ÷ (1 + z_i)^i, where z_i is the spot rate for that date. It is the price equivalent of a zero rate. A 3.3% two-year rate gives a two-year discount factor of 0.9371.
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