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Subject 2. Pricing and Valuation of Forward Contracts PDF Download

Pricing and Valuation at Expiration

At expiration T, the value of a forward contract to the long position is:

VT(T) = ST - F0(T)

where ST is the spot price of the underlying at T and F0(T) is the forward price.

The forward price is the price that a long will pay the short at expiration and expect the short to deliver the asset.

Pricing and Valuation at Initiation Date

There is no cash exchange at the beginning of the contract and hence the value of the contract at initiation is zero.

V0(T) = 0

The forward price at initiation is:

F0(T) = S0(1 + r)T

Example

Consider a forward contract on a non-dividend paying stock that matures in 6 months. The current stock price is $50 and the 6-month interest rate is 4% per annum. Compute the forward price, F.

Solution: Assuming semi-annual compounding, F = 50 x 1.02 = 51.0.

If we add benefits ʇ (dividends, interest, and convenience yield), and costs θ the forward price of an asset at initiation becomes

F0(T) = S0(1 + r)T - (ʇ - θ) (1 + r)T

Pricing and Valuation during the Life of the Contract

The value of a forward contract after initiation and during the term of the contract change as the price of the underlying asset (S) changes. The value (profit/loss) of a forward contract between initiation and expiration is the current price of the asset less the present value of the forward price (at expiration).

User Contributed Comments 10

User Comment
lordcomas Didn't understand the example part of the formula -50$
lordcomas Never mind, got it.
ashish100 Can some one explain the second part of the example? Went 0 - 100 real quick.
grangermac @ashish100 Yeah it did. This is just how I see it, doesn't mean I'm right haha. I assume you mean the coupon payments (-50x1.04-50). Since the bond pays semiannual coupons of $50 each, the first is payed out 6 months from the end of the contract. Therefore you must compute the forward price of this payment ( 6 months @ 8% pa. = 50x1.04). Since the last payment is made right before delivery there is no need to adjust for time value. Think a time line make it a bit more clear if that still doesn't make sense.
vik7868 @Grangemarc I did stuck upon this too. But you explained it really well.
cfashruti In 2nd example, why the benefits have been subtracted? Aren't they supposed to be added?
cfashruti Ok got it
TheCFAGuy Long Position = Buy side
Short Position = Sell side
Katek I still don't get why the benefits have been subtracted, can anyone explain?
breh benefits need to be subtracted because a forward contract implies owning the underlying stock in the future date for the long side, thus any benefits before the expiration date are missed, and any cost in between is avoided. The missed benefits therefore devalue the contract and avoided cost increases the value on the opposite.
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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
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