What is an interest rate forward curve?

Forward curves are derived from financial contracts that price and/or settle based on future settings for the underlying index. For instance, the SOFR forward curve is derived by observing where contracts like SOFR futures and SOFR swap rates trade. These forward curves may then be used to price SOFR-based derivatives including swaps, floors, and interest rate caps, and may be used by borrowers for different aspects of underwriting and budgeting.

What does the forward curve represent?

Many assume that the forward curve represents the market’s current expectations or prediction for future interest rates. It is more accurate to think of the forward curve as the equivalent of a betting line for future settings of a base rate like SOFR. It shows the levels for a future base rate which drives supply-demand equilibrium today for financial contracts and instruments tied to those settings. Said another way, it represents the market's net position or indifference between fixing and floating for various terms. The forward curve is live and will shift as market forces move, especially at points farther along the curve.

The chart below shows actual rate outcomes compared to the forward curve “projections”. It is important to note that when rates do move, they tend to move far more dramatically (upwards or downwards) than implied by the forward curve. These movements tend to be driven by unexpected occurrences in the market (rate hikes/cuts, financial crises, material economic data releases, and global events). Other economic data and known events, like expected rate hikes/cuts, are reflected in the forward curve and so have minimal influence at the point at which they are announced.

1-month USD LIBOR vs. historical forward curves

How is a SOFR forward curve constructed?

The short end of the forward curve (up to two years) is constructed using SOFR future contracts (a liquid futures market reflecting the anticipated SOFR on the settlement date) which are cash-settled.

The middle of the forward curve (two to 10 years) and the long end of the curve (>10 years) is primarily constructed using swap rates. Unlike the other factors used to this point, swap rates do not represent a single point, but a series of points (e.g., a 10-year swap rate paid monthly represents 120 data points). Swap rates add constraints to the curve and generally comprise the dates greater than two years out from the forward curve date. Swap rates, like Eurodollar future rates, are changing constantly throughout the day because of movements in the market, causing the forward curve to change moment-to-moment.

The individual future rates implied by these instruments are converted into a curve using a convexity adjustment – basically using market accepted algorithms to connect the points in a smooth manner while following a series of market-provided constraints.

How should a forward curve be used?

Borrowers use forward curves for a variety of underwriting and pricing purposes. The forward curve can be used as a baseline projection of future interest rates to support investment analysis. The forward curve can be “shocked” (moved upwards or downwards) to model different return scenarios, to stress debt service requirements, and to evaluate exit and refinance risk. The volatility associated with the forward curve (i.e., its propensity to change shape¹ and move upwards or downwards) affects both fixed- and floating-rate debt, and the forward curve can be used to assess hedging strategies associated with current and future financing. Borrowers and lenders frequently use the forward curve as a component of interest rate projections for sizing interest reserves, and asset and portfolio managers often use forward curves for budgeting interest expense for floating-rate debt.

Aside from providing a baseline for underwriting a new investment, the forward curve establishes an important benchmark for derivatives used to implement interest rate hedging strategies. The forward curve is used to establish the mid-market swap rate as it projects the expected future floating-rate cash flows used to calculate the fixed rate (more info on interest rate swaps). The forward curve is also used to determine the payment associated with terminating a swap early, as it allows comparison of the remaining contractual swap cashflows to those implied by future index rate resets (like SOFR) in the curve.

Because of the “live” nature of the forward curve, and the swap rates derived from it, it is important to be aware of these movements as they have material impact on the swap rate which can be achieved (in turn impacting cost of funds/debt service), and also when calculating swap breakage payments if a synthetically fixed-rate loan (swapped floater) is being prepaid. Similarly, the forward curve impacts the pricing of option products like interest rate caps and floors as an input to pricing along with market volatility. Caps with strikes that fall within or close to the forward curve will have pricing that is very sensitive to changes in the forward curve. In either case having real time information is important for getting best pricing when executing caps and swaps, and a reason why many borrowers engage Chatham when doing so.

¹ A forward curve is constantly moving as it responds to new economic news, data, and other changes in the market. Different points along the curve can move at different rates. For example, if the Fed raises short term interest rates in the U.S., the front end of the curve will likely move up. But if the market perceives that decision to be damaging for the economy on a longer-term basis, the back end of the curve may come down, flattening the curve. A positive change in market sentiment regarding the longer-term prospects for the economy may cause the back end to rise relative to the front end, causing the curve to steepen.