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.
How accurate are forward curves?
Dive deeper into how forward curve projections are rarely right, but still valuable inputs for underwriting.
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.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0307
Our featured insights
Bank of England continues with a 50 bps rate hike
On 22 September, the Bank of England (BoE) voted five to four to raise the U.K. base rate by 0.50% to 2.25%. The voting committee’s newest member, Swati Dhingra, voted for a lower 0.25% hike while the remaining dissenters voted for a higher 0.75%. While the hike matches the BoE’s largest ever...
Fed remains steadfast to their rate hikes
On Wednesday, September 21, the Federal Open Market Committee (FOMC) voted unanimously to raise the federal funds target range by 75 basis points to 3.00–3.25%. This rate hike is guided by their long-term goal of stabilizing prices while simultaneously ensuring maximum employment. The Fed is...
Chatham's Q4 2022 outlook: Inflation, market volatility, and LIBOR transition
Watch Chatham's Managing Partner and Chair, Amol Dhargalkar, discuss key trends for the upcoming quarter like inflation, market volatility, and LIBOR transition.
Recapping Powell's Jackson Hole 2022 speech
Chair Powell’s speech today at Jackson Hole was all about inflation, a notable shift from the 2021 Jackson Hole symposium which was more focused on the labor market. The speech concentrated on three key lessons the central bank has learned: taking key responsibility for delivering low and stable...
Bailey enacts biggest rate rise since 1995
On August 4, the Bank of England (BoE) voted eight-to-one to raise the U.K. base rate by 0.50% to 1.75%, with the lone dissenter voting in favour of a more modest 0.25% hike. This was the sixth straight hike by the BoE and the first 0.50% hike since it became independent from the U.K. government...
FOMC continuing course with large rate hikes
On Wednesday, July 27, the Federal Open Market Committee (FOMC) voted unanimously to raise the federal funds target range by 75 basis points to 2.25–2.50%. This is the second consecutive meeting that resulted in a three-quarters of a percent increase intending to subdue inflation that's been...
Cost of leverage in a volatile rate environment
Along with a backdrop of rising interest rates over the course of the year, rate volatility has increased substantially. Treasury yields and swap rates at both the short and long end of the curve have exhibited significant variance in relatively short time periods (including overnight) as a...
In Commercial Property Executive, Robert Mangrelli discusses how the capital markets are reacting to higher interest rates
In a Q&A with Commercial Property Executive, Robert Mangrelli examines how the Federal Reserve's recent interest rate hikes are changing the landscape of commercial real estate's capital markets.