 forward rates are the rates that may be derived from the yield curve and in fact these are the market interest rates at forward interest rates commitments for forward lending and foreign borrowing arrangements are made. Now what is a forward loan? A forward loan is an arrangement now to make a loan at some future date and in this type of loan the parties agree today on the interest to be charged in on that particular loan but the loan would not be convinced until some time in the future. Now the question arises that how to price a forward loan the answer is that the forward rate of interest is there for the period of the particular forward loan so this is the rate at which the forward loan can be priced to understand this mechanics we have a particular example where the price of a zero coupon bonds for year one the bond value is 952.38 dollars and at the end of year two the bond has a price of 890 dollars the YTM on these this bond is for year one the bond has a YTM of 5% and for year two the bond has a YTM of 6% the forward rate of the second year using the particular forward formula the value comes to 7.01% now we considered the strategy laid out in another step that initial cash flow at time not is equal to zero so by a one year zero at 952.38 dollars this means that we are lending this amount receive 890 dollars for each zero maturing in two years that means that the proceeds are coming against this bond then we need to sell these proceeds at 1.0701 this is the growth factor of these bonds multiplying our proceeds with this growth factor this will make the initial cash flows equal to zero we have a particular computation here which is says that by a one year zero at 952.38 dollars that is our initial cash outflow sell 1.0701 two years and that we are taking back the proceeds of our loan which is 952.38 the resulting cash flow is zero so net cash flow we have zero in this particular case and if we generalize our values then we see that by a one year zero coupon bond that is negative B0 into one that B0 is basically the bonds value at a time zero sell 1.0701 two years bond this is plus B0 into two multiplied by 1.1 plus F2 so F2 is the forward rate and B0 to is the bond value at the end of year two and this expression again says that the resulting value is equal to zero so initial cash flow and the resulting cash flows the net value of these two cash flows is equal to zero then in fact we are engineering a synthetic forward loan and how we are doing it let's start it in effectively we are borrowing one thousand dollars a year from now then we are repaying at a growth factor of 1.070.1 a year later this means that the rate on this forward loan is therefore 7.01% this is precisely equal to the forward rate for the year two and if we see the graph here it starts from zero at year one we are receiving we are receiving the one thousand dollars and at year two we are multiplying this value with the growth factor and the net value of these cash flows is equal to zero then with reference to the general forward rate the short rates in the two periods are R1 which is in fact observed today and R2 which is not so we have an R1 today that is our known rate of interest but we don't know the rate of interest at the year two which is R2 the rate that can be locked in for a one period ahead loan is F2 and that starts at the end of year one F2 is then the rate on the forward loan so to price the forward loan we are using the F2 as the forward rate of interest if we see the picture we have R1 for the one year to price the cash outflow of one thousand dollars and inflow of one thousand dollars and for year two we have R2 that is the forward rate of interest which we use to price the forward loan now we see that a synthetic forward loan can be constructed for beyond two years and even it can be constructed constructed for multiple periods of time let's say have another example if anyone wants to obtain such loan beginning in year three and ending in year five then he may issue a five years zero coupon bond this means in fact he is borrowing for the five years and in the next step he is buying a three years zero bond this means that he is lending for a three year so issuing a bond means borrowing a money and buying a three year bond means lending that particular money for a particular three years period these two positions like first borrowing for five years and then lending for three years these two positions are canceling out for the first three years this means that effectively this position leaves this particular person with a borrowing position starting after the year three and it goes on until the end of the year five