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A forward curve is a visual representation of forward rates that share the same maturity date over a specific period. It is a type of interest rate on a financial instrument that commences in the future, matures on a due date and accumulates interest until maturity. Traders and portfolio managers commonly use forward curves to either manage risk of a portfolio or determine the present value of future returns from a specific financial instrument, such as commodity trades, bonds and options. Manufacturers can also use forward curves to offset price fluctuations of raw materials by purchasing correlated raw material futures, called price locking.
Forward 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 continual deflation. Since most economies experience steady inflation over time, the interest rate must be higher than the inflation rate in order to lure investors. In a commodity market, a forward curve reveals prices based on demand expectations, plus holding and storage costs of 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 as the length of time increases. In a commodity market, upward sloping curves indicate that sellers demand compensation for the additional costs associated with holding and storage. A downward slope can be a sign of a bullish market, where future months are discounted. A bullish 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 for creating forward curves. Depending on the complexity of the market, spreadsheets are the most popular method. Forward interest rates for creating forward curves are calculated by taking the market spot rate or from the cash market Libor rates. These two rates often differ because of supply and demand or when the futures market is either driving or plummeting the cash market.
Caution should be taken when developing a forward curve, as miscalculations can lead to mispricing of financial instruments or errors in risk estimation. Forward curves range in complexity, depending on the nature of the financial instrument. In general, a forward curve for bonds is simpler to develop than that of a commodity trade. For instance, some commodity trades have seasonal variations that need to be accounted for depending on the length of time being graphed.
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