Davies returned to the City Ground for a second spell as manager in February, and he helped revive the club's play-off hopes as they reeled off six consecutive victories.
Forest missed out on a top-six place after winning only one of their last eight games, but they are currently fourth in the Championship this season having lost only one of their opening 11 fixtures.
Davies has now signed a new deal which commits him to Forest until the end of the 2016/17 season, and chairman Fawaz Al Hasawi is delighted with the news.
Al Hasawi said: "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."