Forward curve
A forward curve is a graphical representation of the relationship between the price of a commodity or financial instrument and the time at which it is expected to be delivered. It is used to predict the future price of a commodity or financial instrument based on current market conditions. Forward curves can be used in a variety of applications, such as risk management, pricing of derivatives, and investment decision-making. They are commonly used in the energy, commodity, and financial markets.
Forward curve applications
There are several ways to use a forward curve in financial analysis and decision-making:
- Hedging: Forward curves can be used to hedge against price risk by locking in a future price for a commodity or financial instrument. This can help companies and investors protect against price fluctuations.
- Pricing of derivatives: Forward curves can be used to price derivatives, such as futures and options contracts, which are based on the price of a underlying asset.
- Investment decisions: Forward curves can provide insight into the expected future price of a commodity or financial instrument, which can be used to make investment decisions.
- Risk management: Forward curves can be used to identify and manage different types of price risk, such as basis risk, which occurs when the price of the underlying asset differs from the price of the derivative.
To use a forward curve, one would typically gather market data on the commodity or financial instrument in question and plot the data on a graph. The x-axis represents the time to delivery and the y-axis represents the price. The resulting curve can be used to make predictions about future prices and to identify trends in the market.
It's worth mentioning that forward curve can be used in a more complex method called quantitative modeling and arbitrage, which is a technique that uses mathematical models to identify and exploit mispricings in the market.
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References
- Koekebakker, S., & Ollmar, F. (2005). Forward curve dynamics in the Nordic electricity market. Managerial Finance.
- Geman, H., & Nguyen, V. N. (2005). Soybean inventory and forward curve dynamics. Management Science, 51(7), 1076-1091.
- Borak, S., & Weron, R. (2008). A semiparametric factor model for electricity forward curve dynamics. Humboldt-Universität zu Berlin, Wirtschaftswissenschaftliche Fakultät.
