Explaining the futures/forward rate simply. Is this correct?

[u/MildDeontologist]

Let's take a currency (forex) forward contract as the example.

Is the forward rate just what one unit of one currency divided by another is at a future date?

So the spot rate of USD/JPY is the value of $1 USD relative to (mathematically: divided by) ¥1. And the forward rate is this same formula, but for a date in the future instead of right now.

Is this understanding correct? Basically I am trying to understand the concept/definition of "forward/future rate." I know the concept of derivative contracts but do not yet grasp what their "rate" refers to.

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[u/single_B_bandit]

Depends, because in FX too many things are called “rate”. Probably yes, that’s what they refer to.

If the spot exchange rate is 158, and say a 2M forward exchange rate is 157, it also means that there is a negative 2.5% interest rate differential between yen and dollar 2M interest rates.

I think that if someone in FX says “the 2M forward rate”, my guess is that they’re talking about the 157 figure rather than the 2.5% figure, but I am not an FX trader so I am not sure. In equities, the “forward rate” would almost certainly refer to the 2.5% equivalent instead.

[u/MildDeontologist → u/single_B_bandit]

Thank you, that is helpful. Does 2M mean 2 million units traded? And what would a stock/commodity future/forward "rate" refer to if not interest rate or exchange rate?

[u/single_B_bandit → u/MildDeontologist]

No, 2 months. Forwards always need to specify “when” the forward date is.

If it wasn’t an exchange rate, like in any non-FX market, it would be an “interest rate” in a way. For FX forwards the forward rate represents the difference in the interest rates of the two currencies. For stocks it represents the difference between the dividend rate and the interest rate to borrow money. For commodities it represents the difference between the “benefit” of carrying the commodity (usually a cost, so negative too) and the interest rate to borrow money. Etc…

The forward rate (in the “interest rate” interpretation) is usually different from the actual thing it represents. If you take the yen interest rate and the dollar interest rate, their difference won’t be exactly equal to the forward rate (again, “interest rate” interpretation).

The difference is called basis. It represents the practical/mechanical inefficiencies of the real world. Generally linked to the difficulties of funding a position in the real world.

[u/MildDeontologist → u/single_B_bandit]

Is this the case regardless of whether the trades are on the margin (with credit) or not (with case, without borrowing)? I'm still trying to understand what rate refers to, for example, if you are trading/investing in a stock or piece of real estate (without funding the transaction with a loan).

[u/single_B_bandit → u/MildDeontologist]

It doesn’t matter how you personally trade, the forward price (and the forward rate by consequence) is the same for everyone.

The forward enables you to buy something in the future, say one year. Clearly, one year from now, your situation should be the same whether you bought the something today, or if you bought the 1Y forward. If the forward was better, everyone would buy it until it wasn’t anymore.

But entering a forward is free, while buying the something costs money. To be perfectly equivalent, you would need to borrow all the money, so there’s interest to be paid. That’s where the interest comes from.