What Is the Implied Rate?

The implied rate refers to the interest rate discrepancy between the spot interest rate and the rate set for a forward or futures contract delivery date. This metric is crucial for investors to evaluate returns and make informed investment decisions.

Key Takeaways:

• The implied rate represents the difference between the spot rate and the forward or futures rate.
• Investors use the implied rate to assess returns and compare different investment opportunities.
• Any security with an associated option or futures contract can have an implied rate calculated for it.

Understanding the Implied Rate

The implied interest rate is a powerful tool for investors to gauge investment returns and risks. By calculating the implied rate, investors can evaluate the risk-return profile of a security with an option or futures contract.

To illustrate, suppose the current U.S. dollar deposit rate is 1% for spot trades and 1.5% for trades one year ahead. In this scenario, the implied rate equals the 0.5% gap between the two rates. Similarly, when comparing the spot price of a currency at 1.050 with the futures contract price at 1.1071, the 5.71% variance equates to the implied interest rate. Positive implied rates indicate market expectations of future loan rates climbing.

The implied rate calculation involves taking the ratio of the forward price divided by the spot price. This ratio is then raised to the power of 1 divided by the time until the forward contract matures, with 1 subtracted from the result.

• Implied rate = (forward price / spot price) ^ (1 / time) – 1

where time = length of the forward contract in years

Implied Rate Examples

Commodities

For example, if the spot price of a barrel of oil is $68 and the one-year futures contract price is $71, the implied interest rate can be calculated as follows:

Implied rate = (71/68)^(1/1) – 1 = 4.41%

By dividing the futures price by the spot price and adjusting for the contract length, one can determine the implied interest rate to be 4.41%.

Stocks

Another instance involves a stock trading at $30 with a two-year forward contract at $39, resulting in an implied interest rate of:

Implied rate = (39/30)^(1/2) – 1 = 14.02%

Calculating the ratio of the forward and spot prices for a two-year period yields an implied interest rate of 14.02%.

Currencies

Lastly, if the euro’s spot rate is $1.2291, and the one-year futures price is $1.2655, the implied interest rate computes to:

Implied rate = (1.2655 / 1.2291)^(1/1) – 1 = 2.96%

Determining the ratio of forward to spot prices over a one-year period reveals an implied interest rate of 2.96%.