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Subject 2. Off-market forward contract
An off-market forward contract (off-market FRA) is established with a nonzero value at the start. The contract will, therefore, have a positive or negative value and require a cash payment at the start.
- A positive value if paid by the long to the short.
- A negative value is paid by the short to the long.
In an off-market forward contract, the forward price will not equal the price of the underlying asset compounded at the risk-free rate but rather will be set in the process of negotiation between the two parties.
Practice Question 1The price of a stock is $100 now. A forward contract on the stock that expires in one year is currently priced at $110. The annual risk-free rate is 6.75%. Is this an off-market FRA?Correct Answer: S0 = $1,000
F(0, T) = $1,100
T = 1
V0(0, T) = 100 - 110/1.0675 = -$3.04.
Because the value is not zero, this is an off-market FRA. The payment is made by the short to the long as the value is negative.
Study notes from a previous year's CFA exam:
a. explain how the value of a forward contract is determined at initiation, during the life of the contract, and at expiration;