The Scottish manager, in his second spell at the City Ground, will remain in charge until 2017, with owner Fawaz Al Hasawi hailing the 49-year-old's long-term vision for the club
The Scot, who is in his second spell at the City Ground, has been rewarded for his side's excellent start to the season, which has seen them rise to fourth in the table.
Davies returned to Forest in February, replacing Alex McLeish after an ill-fated 40-day spell in charge, and has since won 15 of his 30 games at the helm.
Chairman and owner Fawaz Al Hasawi expressed his delight at the news, telling the club's official website: "This is a fantastic day for Nottingham Forest.
"Billy and I have the same long-term vision for the club and I am absolutely delighted that he has agreed to sign an extension to his contract."
"I look forward with great excitement to working alongside him for many years to come as we aim to bring success back to this magnificent club."
Forest, who finished one point shy of the play-off places last term, face Bournemouth on Saturday looking to extend their seven-game unbeaten home run.