What it means
Suppose a company knows it will need a six-month loan starting in six months. It could wait and borrow at whatever the market rate is then, or it could arrange a forward-forward loan with a bank, agreeing the rate now.
The bank then commits to lend the money at the start date and the company commits to repay it at the end. The rate is not guesswork but is derived from today's interest rates for different periods.
If the market rate for twelve months is higher than for six months, the rate for the second half of the year must be higher still, because the twelve-month rate is a blend of the two halves. The bank can lock in that implied rate by borrowing for twelve months and lending the first six months at the shorter rate.
Forward-forward deals were an important early tool for managing interest rate exposure. Today they are largely replaced by forward rate agreements (FRAs), which achieve the same economic result without the loan actually changing hands.
In an FRA the two parties simply settle the difference between the agreed rate and the market rate in cash. The key risks are credit risk and the obligation itself.
Unlike an option, a forward-forward must be honoured, so the borrower pays the agreed rate even if the market rate turns out to be lower. The bank is exposed to the risk that the borrower cannot repay.
Forward-forward rates also appear in analysis, where analysts extract them from the yield curve to see what the market expects for rates at different points in the future. This implied path is useful in budgeting, though it should not be mistaken for a forecast.
In practice
Real-world examples.
Example
A manufacturer will receive a large customer payment in 6 months and plans to invest it for 3 months before a tax payment. It agrees a forward-forward deposit with its bank at a fixed rate. The treasurer now knows exactly how much interest the cash will earn.
Example
A property developer needs a 6-month bridging loan starting in 3 months. The bank quotes a forward-forward rate based on its funding costs for the two dates. The developer accepts, so the cost of the loan can be included in the project appraisal.
Example
A bank's treasury desk looks at the yield curve and calculates the forward-forward rate for the second year. It compares that with the rate it is able to earn on loans and decides whether to fund the loans for one year or two.
Formula
Calculation
Forward-forward rate = ((1 + r2 x t2) / (1 + r1 x t1) - 1) / (t2 - t1), using simple interest, where t is in years
Suppose the 6-month rate is 4.0% a year and the 12-month rate is 5.0% a year. The rate for the six months starting in six months is ((1 + 0.05 x 1) / (1 + 0.04 x 0.5) - 1) / 0.5.
That works out as (1.05 / 1.02 - 1) / 0.5 = (1.029412 - 1) / 0.5 = 0.029412 / 0.5 = 5.88% a year. On a forward-forward loan of $2,000,000 for six months, the interest would be 2,000,000 x 5.88% x 0.5 = $58,800.Case study
Seen in the real world.
Eastbourne Packaging is a fictional company that expects to pay $3,000,000 for new machinery in six months and to repay the bank financing six months later. The finance manager, Daniel, was concerned about a rise in short-term interest rates in the meantime.
The bank quoted a 6-month rate of 4.0% and a 12-month rate of 5.0%, which implied a forward-forward rate of 5.88% for the six-month period beginning in six months. Daniel agreed to this rate, so the interest on the $3,000,000 would be 3,000,000 x 5.88% x 0.5 = $88,200.
In this illustrative example market rates for that period later rose to 6.5%, which would have cost 3,000,000 x 6.5% x 0.5 = $97,500. The company saved $9,300 compared with waiting, but the more important gain was the certainty that allowed the machinery purchase to be approved.
Watch out
Common mistakes.
- Assuming the forward-forward rate is a forecast, when it is derived from current rates and is the rate at which the bank can lock in the position.
- Forgetting that the borrower must still take the loan if rates fall, since it is a firm commitment rather than an option.
- Confusing the forward-forward with a forward rate agreement, which settles only the difference in rates and does not involve an actual loan.
Questions
People also ask.
Why is it called forward-forward?
Both the start of the loan and the end of the loan lie in the future, so the contract looks forward twice.
Is a forward-forward the same as a forward rate agreement?
They give a similar economic result, but a forward-forward involves an actual loan or deposit, while an FRA is settled in cash on the difference.
Where does the rate come from?
It comes from the difference between the rates for the longer and shorter periods, calculated as shown in the formula.
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