Forward curve

Last updated July 16, 2022

The forward curve is a function graph in finance that defines the prices at which a contract for future delivery or payment can be concluded today. For example, a futures contract forward curve is prices being plotted as a function of the amount of time between now and the expiry date of the futures contract (with the spot price being the price at time zero). The forward curve represents a term structure of prices.^[1]

Forward interest rate

A forward interest rate is a type of interest rate that is specified for a loan that will occur at a specified future date. As with current interest rates, forward interest rates include a term structure which shows the different forward rates offered to loans of different maturities. According to the unbiased expectations hypothesis, forward interest rates predict spot interest rates at the time the loan is actually made, but many analysts dispute whether this is true, as it ignores durational risk.^[2]

This figure is part of the lending & credit industry and is related as well to the "expectations theory" which states that forward interest rates can be used as forecasts for future interest rates. Investors expecting higher short-term interest rates are more likely to buy bonds maturing in the short term. If they were to park money into a long term debt they might not be able to make as much interest.

Finance analysts can refer to a graph of forward interest rate values over different time periods, the forward curve, to evaluate the time value of money.

Price forward curve

A Price forward curve (short PFC) reflects specialties of the commodity market such as:

Transporting commodities is costly and time-consuming.
It is costly to store commodities - power storage is often prohibitively expensive.
Many commodities show a strong seasonality, e.g. there is more natural gas demanded (for heating) in winter than in summer.

In order to fairly value and manage the profitability of energy products it is thus necessary to capture these seasonal price dynamics in a forward curve term-structure.

The contract duration of a futures contract is limited by definition and investors have to change their contract during the contract term. Price forward curves help to determine when to do that, two scenarios are possible:^[3]

If the PFC is ascending, i.e. future commodity-contracts will be more expensive than at the moment, this is called contango. The investor will have additional costs as they have to sell their futures to a lower price than what they have to invest for their new futures.
If the PFC is descending, it is a so-called backwardation and investors will make money by exchanging (rolling) their old futures contracts to new ones.

Hourly price forward curve

An hourly price forward curve (HPFC) is the construction of a forward curve at a resolution exceeding that known to the market and is as such able to capture the seasonalities of the electricity spot prices. The construction of an HPFC can be based on the combination of two approaches. A statistical approach examines how spot prices have moved in the past. A fundamental model suggests that the price is set purely by supply and demand (respectively, fuel prices on the merit order curve, and load).^[4]

Related Research Articles

Derivative (finance) Financial instrument

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.

Normal backwardation, also sometimes called backwardation, is the market condition where the price of a commodity's forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping, since contracts for further dates would typically trade at even lower prices. In practice, the expected future spot price is unknown, and the term "backwardation" may refer to "positive basis", which occurs when the current spot price exceeds the price of the future.

Contango Situation when futures prices are above the expected spot price at maturity

Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.

In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).

Futures contract Standard forward contract

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

Forward contract Agreement to sell or buy a good at a specific time and price

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or selling a commodity, security or currency for immediate settlement on the spot date, which is normally two business days after the trade date. The settlement price is called spot price. A spot contract is in contrast with a forward contract or futures contract where contract terms are agreed now but delivery and payment will occur at a future date.

Swap (finance) Exchange of derivatives or other financial instruments

In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

In finance, the yield curve is a graph which depicts how the yields on debt instruments - such as bonds - vary as a function of their years remaining to maturity. Typically, the graph's horizontal or x-axis is a time line of months or years remaining to maturity, with the shortest maturity on the left and progressively longer time periods on the right. The vertical or y-axis depicts the annualized yield to maturity.

Eurodollars are U.S. dollars held in time deposit accounts in banks outside the United States, which thus are not subject to the legal jurisdiction of the US Federal Reserve. Consequently such deposits are subject to much less regulation than deposits within the U.S. The term was originally applied to U.S. dollar accounts held in banks situated in Europe, but it expanded over the years to cover US dollar accounts held anywhere outside the US. Thus a U.S. dollar-denominated deposit in Tokyo or Beijing would likewise be deemed a Eurodollar deposit. The offshore locations of the Eurodollar make it exposed to potential country risk and economic risk.

Rational pricing is the assumption in financial economics that asset prices - and hence asset pricing models - will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset. It is a particular type of interest rate derivative.

In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.

In finance, a single-stock future (SSF) is a type of futures contract between two parties to exchange a specified number of stocks in a company for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to take delivery of the underlying stock in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to deliver the stock in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties - the buyer hopes or expects that the stock price is going to increase, while the seller hopes or expects that it will decrease. Because entering the contract itself costs nothing, the buy/sell terminology is a linguistic convenience reflecting the position each party is taking - long or short.

Volatility smiles are implied volatility patterns that arise in pricing financial options. It is a parameter that is needed to be modified for the Black–Scholes formula to fit market prices. In particular for a given expiration, options whose strike price differs substantially from the underlying asset's price command higher prices than what is suggested by standard option pricing models. These options are said to be either deep in-the-money or out-of-the-money.

The cost of carry or carrying charge is cost of holding a security or a physical commodity over a period of time. The carrying charge includes insurance, storage and interest on the invested funds as well as other incidental costs. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of the funds necessary to buy the instrument.

The forward exchange rate is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. Multinational corporations, banks, and other financial institutions enter into forward contracts to take advantage of the forward rate for hedging purposes. The forward exchange rate is determined by a parity relationship among the spot exchange rate and differences in interest rates between two countries, which reflects an economic equilibrium in the foreign exchange market under which arbitrage opportunities are eliminated. When in equilibrium, and when interest rates vary across two countries, the parity condition implies that the forward rate includes a premium or discount reflecting the interest rate differential. Forward exchange rates have important theoretical implications for forecasting future spot exchange rates. Financial economists have put forth a hypothesis that the forward rate accurately predicts the future spot rate, for which empirical evidence is mixed.

The following outline is provided as an overview of and topical guide to finance:

The expectations hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined purely by current and future expected short-term rates, in such a way that the expected final value of wealth from investing in a sequence of short-term bonds equals the final value of wealth from investing in long-term bonds.

References

↑ von Schwintowski, Hans-Peter; Berlinghof, Britta, eds. (2010). Handbuch Energiehandel (in German) (2 ed.). Berlin: Erich Schmidt Verlag. p. 751. ISBN 978-3503154388.
↑ "All Together Now: The Forward Curve is Not a Forecast".
↑ "Was sind Forward Curves?". finanzen.net (in German). Karlsruhe, Germany: Axel Springer. Retrieved 13 January 2016.
↑ Hildman, Marcus; Jeroen Cornel; Florian Herzog; Dejan Stokic; Göran Andersson. "Robust Calculation and Parameter Estimation of the Hourly Price Forward Curve".{{cite journal}}: Cite journal requires |journal= (help)