What is a ‘Forward Spread’
A Forward Spread is the price difference between the spot price of a security and the forward price of the same security taken at a specified interval. The formula is the forward price minus the spot price.
Another name for Forward Spread is forward points.
BREAKING DOWN ‘Forward Spread’
All spreads are simple equations resulting from the difference in price between two assets although most spreads are based on one single asset. It may be the difference between two maturity months, two different options strike prices, both maturity and options strike and even the difference in price between two different locations. For example, the spread between U.S. Treasury bonds trading in the U.S. future market and in the London futures market.
However, for the specific use in a forward spread, the formula is the price for one asset at the spot price and a forward or deliverable date. Futures and options traders may refer to it as a calendar spread or time spread. However, while a forward spread is similar to a futures spread, it is based on forward contracts, not futures contracts.
The typical forward spread may refer to a calculation using the one-month forward price and the spot price. An “at par” forward spread occurs when the spot price and the forward price are the same. Par in the debt securities world refers to face value.
For example: The spot price of the security is 1.02. The forward price, taken one month later, is 1.07. Therefore, the forward spread is 0.05, or 5 basis points. A basis point is one- hundredth of a point. 100 basis points equals 1% or 0.01.
Using Forward Spreads
Forward spreads give traders the indication of supply and demand over time. The wider the spread, the more valuable the underlying asset is in the future. The narrower the spread, the more valuable it is now. Narrow spreads, or even negative spreads, might result from short-term shortages, either real or perceived, in the underlying asset.
There is also an element of carrying cost. Owning the asset now suggests that there are costs associated with keeping it. For commodities, that can be storage, insurance and financing. For financial intsruments, it could t financing and opportunity costs of putting money to work earning interest.
Carrying costs may change over time. While storage costs in a warehouse may increase, interest rates to finance the underlying may increase or decrease. In other words, traders must monitor these costs over time to be sure their holdings are priced properly.
Trading opportunities may exist when the forward spread is very narrow or very wide. Taking the opposite position could result in an arbitrage profit potential.
The post Forward Spread appeared first on NewsWorld.