Reading 49. Basics of Derivative Pricing and Valuation
Learning Outcome Statements
c. explain how the value and price of a forward contract are determined at expiration, during the life of the contract, and at initiation;
d. describe monetary and nonmonetary benefits and costs associated with holding the underlying asset and explain how they affect the value and price of a forward contract;
CFA Curriculum, 2020, Volume 6
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Subject 3. Pricing and Valuation of Forward Contracts
At expiration T, the value of a forward contract to the long position is:
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.
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
F = 1018.86 x 1.042 - 50 x 1.04 - 50 = $1,000
Pricing and Valuation during the Life of the Contract
The value of a forward contract after initiation and during the term of the contract change as the price of the underlying asset (S) changes. The value (profit/loss) of a forward contract between initiation and expiration is the current price of the asset less the present value of the forward price (at expiration).
User Contributed Comments 8You need to log in first to add your comment.
Didn't understand the example part of the formula -50$
Never mind, got it.
Can some one explain the second part of the example? Went 0 - 100 real quick.
@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.
@Grangemarc I did stuck upon this too. But you explained it really well.
In 2nd example, why the benefits have been subtracted? Aren't they supposed to be added?
Ok got it
Long Position = Buy side
Short Position = Sell side