What is the 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. If the spot price is higher than the forward price, then the spread is the spot price minus the forward price.
Another name for the forward spread is forward points.
- The forward spread is the forward rate less the spot rate, or in the event of a discount rate, the spot rate minus the forward rate.
- Forward spreads can be large, small, negative, or positive, and represent the costs associated with locking in the price for a future date.
- The spread will be different based on how far out the delivery date of the forward is. A one year forward will be priced differently than a 30-day forward.
Understanding the Forward Spread
All spreads are simple equations resulting from the difference in price between two assets or financial products, such as a security and a forward on that security. A spread can also be the price difference between two maturity months, two different option strike prices, or even the difference in price between two different locations. For example, the spread between U.S. Treasury bonds trading in the U.S. futures market and in the London futures market.
For forward spreads, the formula is the price for one asset at the spot price compared to the price of a forward which will be deliverable at a future date. The forward spread can be based on any time interval, such as one month, six months, one year, and so on. The forward spread between spot and a one-month forward will likely be different than the spread between spot and a six-month forward.
When the spot price and the forward price are the same, this means they are trading at par. Par in this context shouldn't be confused with par in the debt markets, which means the face value of a bond or debt instrument.
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. With currency forwards, negative spreads (called discount spreads) occur frequently because currencies have interest rates attached to them which will affect their future value.
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 instruments, it could be financing and the opportunity costs of locking into a future commitment.
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.
Example of a Forward Spread in the Gold Markets
Assume that the cash rate for gold is $1,340.40 per ounce.
A company needs a forward to lock in a rate on 5,000 ounces of gold to be delivered in 30 days. They could buy multiple 100-ounce futures contracts, or they could enter into a one-month forward contract within a gold supplier.
The gold supplier agrees to provide the 5,000 ounces of gold in 30 days at a rate of $1,342.40. The buyer will provide the supplier with $6,702,000 ($1,342.40 x 5,000) at that time as well.
The forward spread is $1,342.40 - $1340.40 = $2.