Implied Forwards

DESCRIPTION

An Implied Forward is that rate of interest that financial instruments predict will be the spot rate at some point in the future.

CALCULATION

If 6 month Libor is 5.00% (180 days) and 3 month Libor is 4.00% (90 days) we can calculate the 3 month forward implied 3 month rate as follows:

(1+0.05)^180/360 = (1+0.04)^90/360 * (1+X)^90/360

X = 6.01%

Therefore the market is implying that in 3 months time, 3 month Libor will be 6.01%. This means that an Investor would be indifferent between receiving 4.00% for 3 months and reinvesting at 6.01% for a further 3 months, and receiving 5.00% for 6 months.

• The Implied Forward is very dependant on the SLOPE of the yield curve.

• In a positively sloped curve, Forward rates are implied to be higher than Spot rates.

• In a negatively sloped curve Forward rates are implied to be lower.

APPLICATIONS

The Implied Forward rate is very important for anyone wishing to take a position in the markets. By definition, all speculative views on the market are only profitable when the rates that occur are different than those implied. Therefore when looking to establish a position, it is important to compare your view with the Implied Forward. If it is the same, there is no opportunity to profit from your view. The difference between the current Spot rate and the Implied Forward is known as the amount "built in" to the market.

The Implied Forward is also used when calculating an FRA rate (see "Forward Rate Agreements").

FORMULA

The formula for calculating Implied Forwards is as follows:

(1+r)^n/12 = (1+s)^m/12 * (1+x)^p/12

Solve for x where:

• r is rate for long period

• s is rate for short period

• n is number of months in long period

• m is number of months in short period

• p is number of periods in implied period

Note: All rates used must be same discount basis