An implied rate is the interest rate that represents the difference between the forward rate and the spot rate associated with a specific investment. Typically, this particular interest rate is calculated by subtracting the present or spot rate from the forward or futures rate. The amount of the implied rate can provide the investor with valuable clues regarding the advantages or disadvantages of entering into a futures contract associated with that particular security or commodity.
In order to understand how the implied rate functions, it is necessary to know what is meant by a spot rate and a forward rate. Essentially, the spot rate is the interest rate that will remain in place over the next couple of trading days. The forward or futures rate is the interest rate that will apply to the security at some specific date over the next several months. Depending on the nature of the investment, the amount of difference between these two rates may indicate that there is a significant benefit to completing the transaction now versus arranging a date to settle in the future.
One example is to consider the London Interbank Offered Rate (LIBOR) that is offered with a specific investment. If the present LIBOR is set at seven percent and the forward LIBOR rate is at nine percent, that means the implied rate is two percent. This calculation indicates to the investor that borrowing will be somewhat more expensive in the future, and may prompt the investor to go with a transaction that is settled while the present rate is still in effect rather than going with some type of futures or forward contract. By contrast, if the present rate is more than the forward rate, this indicates that going with a futures contract may allow the investor to secure the commodity at a better rate later on, while locking in that better rate here and now.
Taking the time to calculate the implied rate can aid investors from entering into what appear to be excellent deals today, but would actually cost more in the long run. Along with considering such factors as future demand for the security or commodity, and the general direction of the marketplace, knowing the implied rate provides valuable clues as to when to execute the transaction and maximize the potential for earning a return. Since very little effort is required to determine the implied rate, it is possible for dealers and brokers as well as investors to assess the potential of the investment quickly, and determine if the security or commodity is a good fit for the overall investment goals related to the investment portfolio.
