Valuation of Forward

Contract
RAVI - IBA

Forward Contract Value Introduction

So far we have talked about calculating a
forward price or futures price for the
purpose of initiating a new contract.
At inception, the value of a forward and
otherwise identical futures are both the
same.
After the inception their values must be
calculated differently, due to the daily
settlement inherent to futures contracts,
which does not take place with forwards

Forward Contract Value

The value of a forward contract after inception
is the present value of the difference between
its delivery price and the delivery price of a
theoretical new contract, ie , the current
forward price. This applies to any forward
contract.
Theoretical new forward Contract : K
Delivery price at Inception is equal to forward
price F
The long party will pay on delivery the
difference F vs K.

 Thus the value of contract in our

hands is thus the present value of
difference between F & K
ForwardValueLong = PV (F-K) = (F-K)*ert

ForwardValueShort = PV (K-F) = (K-F)*ert

Why do we discount ? Because the

difference between F & K is a future
value, and we are interested in a

Illustration
X executes a forward contract with Y, a six
month forward contract, to buy 100
shares of company XYZ , which pays no
dividends and was trading at inception at
$15.50. The risk free interest rate is 2
percent.
At the end of three months, the spot price
of XYZ is $15.80. What is the value of X
position (assuming risk free rate is not
changed?

Illustration contd.

Spot at inception Si = 15.50 * 100 = 1550

r = 0.02 , t0 = 0.5
Heres the forward contract price :
F = S*ert
F = 1550 * e(0.02*0.5) = 1550 * 1.01005
F = 1565.58
The fair market delivery price for this
contract is $1565.58 or $15.66 per share.

Illustration contd.

The new inputs :

Spot at 3 months = 15.80 * 100 = 1580
r=0.03 t3 =0.25
Here is the current forward price :
F = S * e rt = 1591.80
The new forward price (ie fair market delviery price for a
hypothetical new forward contract) is $1591.89.
Say F = 1591.80 K = 1565.58 r= 0.03 t = 0.25
Long value of forward contract:
Value = (F-K)e-rt
Value = (1591.89 1565.58) e-0.03 * 0.25
Value = 26.11

 There is an easier value to calculate the of

a forward contract when there are no costs
or benefits to holding the underlier.
That is no Cost of carry except for interest.
Its is the just difference between spot price
of the underlier and the present value of
the delivery price.
ForwardValueLONG(No.C.C.) = S PV (K) = S Kert

ForwardValueSHORT(No.C.C.) = PV(K) S =Ke-rt - S

Using the previous illustration :

S = 15.80 * 100 = 1580
K = 1565.58 r =0.03 t = 0.25
Putting it all together we have :
S Ke-rt = 1580 1565.58* e0.03 (0.25)
=26.11
The same result as per previous
calculation.

Recap
It is important to distinguish between price and
value this is important for all instruments.
Forward value: is what you can sell something
for or what you must pay to acquire something
valuation, thus, is the process of determining
the value of an asset/ the amount of money that
would be paid to engage in transaction
Forward price: is the fixed price or rate at
which the transaction is scheduled to occur at
expiration pricing, thus, is to determine the
forward price/rate

Recap
Today is identified as 0, expiration date is T, and
t is an arbitrary time between today and
expiration.
The price of the underlying asset in spot market
is S0 at time 0, St at time t, and ST at time T.
Forward contract price when contract is initiated
is F(0,T)
Value of forward contract at time t is Vt(0,T)

 Generic Pricing Form

It is customary in forward markets to set the initial value
at zero (that is, no money should exchange hand at
initiation). For the long party, the value of the forward
contract at initiation is the difference between the spot
price and the present value of the forward price:

If we set this value to be equal to zero, then forward

price (given that T is number of years to expiration) is
be equal to zero, then forward price (given that T is
number of years to expiration) is: