Lecture-1, Section 16, Reading 58, Forward Markets and Contracts

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Dr.Stanley B. Gyoshev Module Leader
Kingkan Ketsiri Tutorial Instructor
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Lecture 1
Session 16, Reading 58
Forward Markets
And Contracts
Dr. Stanley Gyoshev
Xfi Centre for Finance and Investment
University of Exeter
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Learning Outcomes
Explain how the value of a forward contract is

determined at initiation, during the life of the
contract, and at expiration;
Calculate and interpret the price and the value of an

equity forward contract, assuming dividends are paid
either discretely and continuously;
Calculate and interpret the price and the value of 1)

a forward contract on a fixed income security, 2) a
forward rate agreement (FRA), and 3) a forward
contract on a currency;
Evaluate credit risk in a forward contract and explain

how market value is a measure of the credit risk to a
party in a forward contract.
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1. Introduction
Definition of a Forward Contract A forward contract is

an agreement between two parties in which one
party, the buyer, agrees to buy from the other party,
the seller, an underlying asset or other derivative, at
a future date at a price established at the start of the
contract.
Long Position: buyer
Short Position: seller
1.1 Delivery and Settlement
1.2 Default Risk
1.3 Termination of a Contract

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2. The Structure of the Global
Forward Market
For individual reading

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3. Types of Forward Contracts
3.1 Equity Forwards
Forward contracts on individual stocks
Forward contracts on stock portfolios
Forward contracts on stock indices
The effect of dividends
3.2 Bond and Interest Rate Forward Contracts
Forward contracts on individual bonds and bond

portfolios
Forward contracts on interest rates: forward rate

agreements (FRA)
Eurodollar: the primary time deposit

instrument
London Interbank Offer Rate (LIBOR): lending

rate in derivative contracts.
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3. Types of Forward Contracts
3.3 Currency Forward Contracts
3.4 Other Types of Forward Contracts
Commodity forwards: oil, a precious metal, et al.

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4. Pricing and Valuation of
Forward Contracts
Definition:
Value is what you can sell something for or what you
must pay to acquire something. Valuation is the
process of determining the value of an asset or
service.
Definition:
A contract price is the fixed price or rate at which
the transaction scheduled to occur at expiration
will take place, which is commonly called the
forward price or forward rate.
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4.1 Generic Pricing and Valuation of a
Forward Contract
Time-line of the contract

Today is identified as time 0 and is the date the
contract is created. The expiration date is time T.
Time t is an arbitrary time between today and the
expiration.
0 T
t
(today)
The day the
contract is
created
(expiration
)
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Forward Contract
Variable Definitions
S0: spot price at time 0;
ST: spot price at time t;
F(0, T): price of a forward contract initiated at

time 0 and expiring at time T;
Vt(0, T): the value at time t of a forward contract

initiated at time 0 and expiring at time T;
Value at expiration of a forward contract established

at time 0
VT(0, T) = ST F(0, T) (58-1)
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Forward Contract
Determining Forward Price - an Example 1 of 2

Suppose the underlying asset is worth $100 and the forward
price is $108, the interest rate is 5%.
VT(0, T) = ST F(0, T)=108 105=$3
This is an arbitrage profit and the derivative price would have
to come down to $105.
Consider if F = $103 with T = 1, the value of the contract at
present would be
V0(0, T) = S0 F(0, T) / (1+r)T
= 100 103 / (1+0.05) = $1.9048
If a party is longing a contract, it must pay $1.9048 to the
party shorting the contract.
NB! Parties going long must pay positive values; parties
going short pay negative values.
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Forward Contract
Determining Forward Price Example 2 of 2

If the forward price were $108, the value would be
V0(0, T) = S0 F(0, T) / (1+r)
= 100 108 / (1+0.05) = -$2.8571
To eliminate this arbitrage profit, this value would have to be
paid from the short to the long.
Determining Forward Price

It is customary in the forward market for the initial value to be
set to zero.
V0(0, T) = S0 F(0, T)/(1+r)
F(0, T) = S0(1+r)T (58-2)
So in the above example:
F(0, T) = S0 * (1+r)T = 100 * (1+ 0.05) = $105
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4.1 Exhibit 3: Generic Pricing and Valuation
of a Forward Contract
Determining Forward Price (2)
F(0, T) = S0(1+r)T
Off-market FRA: a contract in which the initial value

is intentionally set at a nonzero value.
Buy asset at S0
Sell forward contract
at F(0, T)
Outlay: S0
Hold asset
and lose
interest on
outlay
Deliver asset
Receive F(0, T)
0 T
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Forward Contract
The Value of a Forward Contract at Time t

Vt(0, T) = St F(0, T)/(1+r)(T t) (58-3)

Example: St = $102, F(0, T) = $105, t = 0.25, T = 1
Vt(0, T) = V0.25(0, 1)
= 102 105 / (1 + 0.05)^(1 0.25)
= $0.7728

If the market value is positive, the value of the asset
exceeds the present value of what the long promises
to pay. Thus it makes sense that the short must pay
the long and vice versa if the market value is
negative.
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4.1 Exhibit 4: Generic Pricing and Valuation
of a Forward Contract
The Value of a Forward Contract at Time t (2)

Vt(0, T) = St F(0, T)/(1+r)(T t)
Example: St = $71.19, F(0, T) = $62.25, t = 1.5, T = 2, r = 7%
Vt(0, T) = V1.5(0, 2) = 71.19 62.25/(1 + 0.07)0.5 = $11.01
Went long forward
contract at price
F(0, T)
Outlay = 0
Hold a claim on asset
currently worth ST
Obliged to pay F(0,
T) at T
Receive asset
worth ST
Pay F(0, T)
0 T
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4.1 Exhibit 5: Pricing and Valuation for a
forward Contract
Value of a forward contract at any time
Vt(0, T) = St F(0, T)/(1+r)(T t)
Value of a forward contract at expiration (t=T)
VT(0, T) = ST F(0, T)
Value of a forward contract at initiation (t=0)
V0(0, T) = S0 F(0, T)/(1+r)T
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Example 1A
An investor holds title to an asset worth $125.72. To
raise money for an unrelated purpose, the investor
plans to sell the asset in nine months. The investor
is concerned about uncertainty in the price of the
asset at that time thus he enters a forward contract
to sell the asset in 9 months. The risk-free interest
rate is 5.625%.
A. Determine the appropriate price for the forward.
Solution S0 = 125.72
T = 9/12 = 0.75
r = 0.05625
F(0, T) = 125.72(1.05625)0.75 = 130.99
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Example 1B
B. Suppose the counterparty to the forward contract is
willing to engage in such a contract at a forward
price of $140, Explain what type of transaction the
investor could execute to take advantage of the
situation. Calculate the rate of return (annualized),
and explain why the transaction is attractive.
Solution The rate of return:
(140/125.72) - 1 = 0.1136 in 9 months,
which can be annualized to
(1.1136)12/9 1 = 0.1543
The return is obviously larger than the risk-free rate
of 5.625%. The position is not only hedged but also
earns an arbitrage profit.

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Example 1C
C. Two months later, the price of the asset is $118.875.
Determine the market value of the forward contract
at this point in time from the perspective of the
investor in Part A.
Solution t = 2/12
T t = 9/12 2/12 = 7/12
St = 118.875
F(0, T) = 130.99
Vt(0, T) = V2/12(0, 9/12)
= 118.875 130.99/(1.05625)7/12 = 8.0
The contract has a negative value. This investor is
short thus the value to the investor in this problem is
gain of 8.0.

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Example 1D
D. Determine the value of the forward contract at
expiration assuming the contract is entered into at
the price you computed in A and the price of the
underlying asset is $123.50 at expiration. Explain
how the investor did on the overall position of both
the asset and the forward contract.
Solution ST = 123.50
VT(0, T) = V9/12(0, 9/12) = 123.50 130.99 = 7.49
.
The investor is short so she gains 7.49 on the
forward contract.
.
She incurred a loss on the asset of 125.72 123.50
= 2.22.
.
Therefore the net gain is 7.49 2.22 = 5.27, which
represents a return of 5.27/125.72 = 4.19%.
.
When annualized the return equals (1.0419)12/9 =
0.05625, the same as the risk-free rate.

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4.2 Pricing and Valuation of Equity
Forward Contracts
The Present Value of Dividends
Price of Equity Forward Contracts Paying Dividends

F(0, T) = [S0 PV(D,0,T)](1+r)T (58-4)
Example
S0 = $40, dividend of $3 in 50 days, r = 6%, T = 0.5
F(0, T) = F(0, 0.5) = [40-3/(1.06)50/365](1.06)0.5 =
$38.12
NB! Forward price should not be interpreted as a

forecast of the future price of the underlying.
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Forward Contracts

using Future value
F(0, T) = S0*(1+r)T FV(D,0,T) (58-5)

using Continues Compounding
(58-6)
( ) ( )
T r T
c c
e e S T F

0
, 0
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Forward Contracts
The Value of Equity Forward Contracts Paying

Dividends
Vt(0, T) = St PV(D,t,T) F(0, T)/(1+r)(T t) (58-7)

The Value of Equity Forward Contracts Paying

Dividends with continuous compounding
(58-8)
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4.2 Exhibit 6: Pricing and Valuation
Formulas for Equity Forward Contracts
Price of Equity Forward Contract

Discrete Dividends
F(0, T) = [S0 PV(D,0,T)](1+r)T or S0 (1+r)T FV(D,0,T)
Continuous Dividends
Value of Equity Forward Contract

Discrete Dividends
Vt(0, T) = St PV(D,t,T) F(0,T)/(1 + r)(T t)
Continuous Dividends
( ) ( )
T r T
c c
e e S T F * , 0
0

( )
( )
( )
( ) t T r t T
t t
c c
e T F e S T V

, 0 , 0

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Forward Contracts
Example 2
For individual review
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Formulas for Fixed Income Forward
Contracts
Price of Forward Contract on Bond with Coupons CI

F(0, T) = [B0c(T + Y) PV(CI,0,T)](1 + r)T
Or [B0c(T + Y)] (1 + r)T FV(CI,0,T)]
Price of Forward Contract on Bond with Coupons CI

Vt(0, T) = Btc(T + Y) PV(CI,t,T) F(0,T)/(1 + r)(T-t)
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4.3 Pricing and Valuation of Fixed

Income Forward Contracts
Example 3
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4.3 Pricing and Valuation Formulas for
Interest Rate Forward Contracts (FRAs)
Forward Price (Rate)

(58-13)
Value of FRA on Day g (58-14)

( )
( )
( )

,
_
1
1
1
1
]
1
,
_
,
_
+
+ +
m
h
h L
m h
m h L
m h
000
0
000
0
000
0
, , 0 FRA
0
0
( )
( )
( )
( )

,
_
+
+ +
,
_
,
_
000
0
000
, , 0 FRA 0
000
0
0
, , 0
g m h
g m h L
m
m h
g h
g h L
m h V
g g
g
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4.3 Exhibit 8: Pricing and Valuation Formulas for
Interest Rate Forward Contracts (FRAs)
Forward Price (Rate)

Value of FRA on Day g

( )
( )
( )

,
_
1
1
1
1
]
1
,
_
,
_
+
+ +
m
h
h L
m h
m h L
m h
000
0
000
0
000
0
, , 0 FRA
0
0
( )
( )
( )
( )

,
_
+
+ +
,
_
,
_
000
0
000
, , 0 FRA 0
000
0
0
, , 0
g m h
g m h L
m
m h
g h
g h L
m h V
g g
g
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Forward Contracts
Example 4
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4.4 Pricing and Valuation Formulas for
Currency Forward Contracts
Price of Forward Contract on Foreign Currency
Interest rate Parity

Discrete Interest:
(58-15)
Continuous Interest
(58-16)
( )
( )
( )
T
T
f
r
r
S
T F +
1
1
]
1
+
0
0
, 0
0
( ) ( )
T r T r
c fc
e e S T F

0
, 0
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Formulas for Currency Forward
Contracts (1 of 2)
Price of Forward Contract on Foreign Currency
Interest rate Parity

Discrete Interest:
Continuous Interest
( )
( )
( )
T
T
f
r
r
S
T F +
1
1
]
1
+
0
0
, 0
0
( ) ( )
T r T r
c fc
e e S T F

0
, 0
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Formulas for Currency Forward
Contracts (2 of 2)
Value of Forward Contract on Foreign Currency

Discrete Interest Rate
Continuous Interest Rate
( )
( )
( )
( )
( )
( ) t T t T
f
T
t
r
T F
r
S
T V

+
1
1
]
1
0
, 0
0
, 0
( )
( )
[ ] ( )
( ) t T r t T r
t t
c fc
e T F e S T V

, 0 , 0
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Forward Contracts
Example 5

Lecture-1, Section 16, Reading 58, Forward Markets and Contracts

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1

Explain how the value of a forward contract is

Calculate and interpret the price and the value of an

Calculate and interpret the price and the value of 1)

Evaluate credit risk in a forward contract and explain

Definition of a Forward Contract A forward contract is

Long Position: buyer

Short Position: seller

1.1 Delivery and Settlement

1.2 Default Risk

1.3 Termination of a Contract

For individual reading

3.1 Equity Forwards

Forward contracts on individual stocks

Forward contracts on stock portfolios

Forward contracts on stock indices

The effect of dividends

3.2 Bond and Interest Rate Forward Contracts

Forward contracts on individual bonds and bond

Forward contracts on interest rates: forward rate

Eurodollar: the primary time deposit

London Interbank Offer Rate (LIBOR): lending

3.3 Currency Forward Contracts

3.4 Other Types of Forward Contracts

Commodity forwards: oil, a precious metal, et al.

Time-line of the contract

S0: spot price at time 0;

ST: spot price at time t;

F(0, T): price of a forward contract initiated at

Vt(0, T): the value at time t of a forward contract

Value at expiration of a forward contract established

Determining Forward Price - an Example 1 of 2

Determining Forward Price Example 2 of 2

Determining Forward Price

Determining Forward Price (2)

Off-market FRA: a contract in which the initial value

The Value of a Forward Contract at Time t

The Value of a Forward Contract at Time t (2)

The Present Value of Dividends

Price of Equity Forward Contracts Paying Dividends

NB! Forward price should not be interpreted as a

Price of Equity Forward Contracts Paying Dividends

Price of Equity Forward Contracts Paying Dividends

The Value of Equity Forward Contracts Paying

The Value of Equity Forward Contracts Paying

Price of Equity Forward Contract

Value of Equity Forward Contract

4.2 Pricing and Valuation of Equity

Price of Forward Contract on Bond with Coupons CI

Price of Forward Contract on Bond with Coupons CI

4.3 Pricing and Valuation of Fixed

Forward Price (Rate)

Value of FRA on Day g (58-14)

Forward Price (Rate)

Value of FRA on Day g

4.3 Pricing and Valuation of Equity

Price of Forward Contract on Foreign Currency

Interest rate Parity

Price of Forward Contract on Foreign Currency

Interest rate Parity

Value of Forward Contract on Foreign Currency

4.4 Pricing and Valuation of Equity

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