A forward curve is a visual representation of forward rates that share the same expiration date over a specific period.
A forward curve is a visual representation of forward rates that share the same expiration date over a specific period. It is a type of interest rate on a financial instrument that starts in the future, matures on the maturity date, and accrues interest to maturity. Portfolio traders and managers often use forward curves to manage a portfolio’s risk or determine the present value of future returns on a specific financial instrument, such as trading commodities, bonds, and options. Manufacturers can also use future curves to offset commodity price fluctuations by purchasing correlated commodity futures, called a price lock.
Future curves are often used to determine the time value of money, or how much a dollar today will be worth at some point in the future. The present value of a dollar today is less than the value of a dollar received in the future, unless the economy is experiencing continued deflation. Since most economies experience stable inflation over time, the interest rate must be higher than the inflation rate to attract investors. In a commodity market, a futures curve reveals prices based on expectations of demand, in addition to the costs of carrying and storing inventory.
The shape of a forward curve provides insight into the strength or weakness of the market. Upward sloping curves are considered to be the normal state of markets, where the value increases with increasing time period. In a commodity market, upward sloping curves indicate that sellers demand compensation for the additional costs associated with maintenance and storage. A downward slope can be a sign of a bull market, where future months are discounted. A bull market indicates that demand is strong and that buyers are willing to pay a premium for a reduced waiting period.
Spreadsheets and software are used to create feed curves. Depending on the complexity of the market, spreadsheets are the most popular method. Forward interest rates for creating forward curves are calculated using the spot market rate or the spot market Libor rate. These two rates often differ due to supply and demand or when the futures market is boosting or plummeting the spot market.
Care should be taken when developing a futures curve, as miscalculations can lead to mispricing of financial instruments or errors in risk estimation. Future curves vary in complexity depending on the nature of the financial instrument. In general, a straight curve for bonds is simpler to develop than a commodity trade. For example, some commodity trades have seasonal variations that need to be accounted for depending on the duration of the chart.