Pricing of Forward Contract, Limitations08/09/2022 0 By indiafreenotes
Forward price is the predetermined delivery price for an underlying commodity, currency, or financial asset as decided by the buyer and the seller of the forward contract, to be paid at a predetermined date in the future. At the inception of a forward contract, the forward price makes the value of the contract zero, but changes in the price of the underlying will cause the forward to take on a positive or negative value.
Forward Price Formula
The forward price formula (which assumes zero dividends) is seen below:
F = S0 x e^ (rT)
- F = The contract’s forward price
- S0 = The underlying asset’s current spot price
- e = The mathematical irrational constant approximated by 2.7183
- r = The risk-free rate that applies to the life of the forward contract
- T = The delivery date in years
Underlying Assets with Dividends
For a forward contract with which the underlying asset may incur dividends, the forward price is determined with the following formula:
F = (S0 – D) x e^ (rT)
D = The sum of each dividend’s present value
An economic variation of the formula will be written as:
Cost of Capital = (Fair Price + Future Value of Asset’s Dividends) – Spot Price of Asset
Forward Price = Spot Price – Cost of Carry
Fundamentals of Forward Price
A forward price is arrived at by considering the current spot price of the asset, which is underlying in the contract. Furthermore, carrying charges, such as interest, forgone interest, storage costs, and other costs are also accounted for when arriving at the forward price.
Despite the forward contracts not having an intrinsic value at the time of the agreement, they may gain or lose value depending on a lot of factors with time. Offsetting of positions in forward contracts is comparable with someone’s loss or someone’s gain theory.
For instance, if an investor holds a long position in one of the pork belly agreements and another investor holds a short position, then gains resulting from the long position will be equal to the losses arising to the investor holding the short position.
By setting the initial value of the contract to zero, both the parties of the contract are on the same level at the time of the agreement.
- As it is a private contract, there is no liquidity.
- Counterparty risk of defaulting on the contract is excessively high.
- The market of forward contracts is extremely unorganized as it is traded over the counter.
- It may be challenging to find a counterparty to enter into a contract.
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