Definition in Detail
A Forward Forward Rate is the predetermined interest rate that will be applied to a loan or a deposit over a specific future period. It is set at the present time for a loan or deposit that will begin at a future date and mature at a second future date. This financial instrument is used to hedge against interest rate risk, ensuring that both borrowers and lenders can lock in interest rates for future periods.
Key Characteristics:
- Future Periods: The rate pertains to a loan or deposit that starts and ends at specified dates in the future.
- Fixed Rate: The rate is agreed upon at the present time, providing certainty about future costs or returns.
- Hedging Tool: Commonly used to hedge against adverse movements in interest rates.
Examples
- Example 1: A business anticipates needing a $1 million loan in six months’ time. To protect against the risk of rising interest rates, the business enters into a Forward Forward Rate agreement with a bank to lock in an interest rate of 4% for a one-year loan, starting six months from now.
- Example 2: An investor holds a large sum of money that will only be available in three months. They negotiate a Forward Forward Rate agreement to deposit that money for six months at an interest rate of 3% starting three months from the current date.
Frequently Asked Questions
Q1: What is the primary purpose of a Forward Forward Rate? A: The primary purpose is to manage interest rate risk by locking in interest rates for periods in the future, thereby providing certainty about future borrowing or investing costs and returns.
Q2: How is a Forward Forward Rate different from a standard forward rate? A: While both terms deal with future interest rates, a Forward Forward Rate specifically applies to the borrowing or lending of funds that will occur within future periods. A standard forward rate generally refers to the future rate implied today by current interest rates.
Q3: Who typically uses Forward Forward Rates? A: They are typically used by financial institutions, corporations, and investors who seek to hedge against future interest rate fluctuations.
Q4: How are Forward Forward Rates calculated? A: Forward Forward Rates are derived from the current yield curve and interest rate derivatives. They are calculated using relationships between spot rates and forward rates.
Q5: Can Forward Forward Rates also be applied to currencies? A: Yes, there are Forward Forward Rates for currency pairs, used in the FX markets to lock in future exchange rates.
Related Terms with Definitions
- Forward Rate: The agreed-upon interest rate for a future period, derived from the current yield curve and interest rate projections.
- Yield Curve: A graph that plots the yields of similar quality bonds against their maturities, used to deduce Forward Forward Rates.
- Spot Rate: The current interest rate for immediate transactions, as opposed to future periods.
- Interest Rate Swap: A financial instrument used to exchange interest rate payments for another, often to manage interest rate risk.
- Futures Contract: A standardized legal agreement to buy or sell an asset at a predetermined price at a specific future date.
Online Resources
Suggested Books for Further Studies
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- “Interest Rate Swaps and Other Derivatives” by Howard Corb
- “Modern Portfolio Theory and Investment Analysis” by Edwin J. Elton and Martin J. Gruber
- “Options, Futures, and Other Derivatives” by John C. Hull
- “Financial Markets and Institutions” by Frederic S. Mishkin and Stanley G. Eakins
Accounting Basics: “Forward Forward Rate” Fundamentals Quiz
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