A forward curve is a representation of forward rates with the same maturity date over a specified period. It is used to manage portfolio risk, determine present value, and offset commodity price fluctuations. The shape of the curve indicates market strength or weakness. Caution is advised when developing a forward curve.
A forward curve is a visual representation of forward rates that share the same maturity date over a specified period. It is a type of interest rate on a financial instrument that begins in the future, matures at a maturity date, and accrues interest until maturity. Traders and portfolio managers often use forward curves to manage portfolio 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 forward curves to offset commodity price fluctuations by buying correlated commodity futures, called price locks.
Forward curves are often used to determine the time value of money, or how much a dollar will be worth today 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 experiences continued deflation. Since most economies experience constant inflation over time, the interest rate must be higher than the inflation rate to attract investors. In a commodity market, a forward curve reveals prices based on demand expectations, plus inventory holding and storage costs.
The shape of a forward curve provides information about the strength or weakness of the market. Upward sloping curves are considered the normal state of markets, where value increases as time increases. In a commodity market, rising curves indicate that sellers are demanding compensation for the additional costs associated with holding 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 buyers are willing to pay a premium for a reduced waiting period.
Spreadsheets and software are used to create forward curves. Depending on the complexity of the market, spreadsheets are the most popular method. Forward interest rates to create forward curves are calculated by taking the market spot rate or cash market Libor rates. These two rates often differ due to supply and demand or when the futures market is rising or plummeting.
Caution should be exercised when developing a forward curve, as miscalculations can lead to mispricing of financial instruments or risk estimation errors. Forward curves vary in complexity, depending on the nature of the financial instrument. In general, a forward curve for bonds is easier to develop than one for a commodity trade. For example, some commodity exchanges have seasonal variations that need to be taken into account depending on the time it is charted.
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