Forward price

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The forward price or forward rate is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, we can express the forward price in terms of the spot price and any dividends etc., so that there is no possibility for arbitrage.

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[edit] Forward Price Formula

The forward price is given by:

F = S_0 e^{(r-q)T} - \sum_{i=1}^N D_i e^{(r-q)(T-t_i)} \,

where

F is the forward price to be paid at time T
ex is the exponential function (used for calculating compounding interests)
r is the risk-free interest rate
q is the cost-of-carry
S0 is the spot price of the asset (i.e. what it would sell for at time 0)
Di is a dividend which is guaranteed to be paid at time ti where 0 < ti < T.

[edit] Proof of the forward price formula

The main dilemma here is what price should the short position (the seller of the asset) offer to maximize his gain; what price should the long position (the buyer of the asset) accept to maximize his gain?

At the very least we know that both do not want to lose any money in the deal.

The short position knows as much as the long position knows: the short/long positions are both aware of any schemes that they could partake on to gain a profit given some forward price.

So of course they will have to settle on a fair price or else the transaction cannot occur.

An economic articulation would be:

(fair price + future value of asset's dividends) - spot price of asset = cost of capital

The future value of that asset's dividends (this could also be coupons from bonds, monthly rent from a house, fruit from a crop, etc.) is calculated using the risk-free force of interest. This is because we are in a risk-free situation (the whole point of the forward contract is to get rid of risk or to at least reduce it) so why would the owner of the asset take any chances? He would reinvest at the risk-free rate (i.e. U.S. T-bills which are considered risk-free). The spot price of the asset is simply the market value at the instant in time when the forward contract is entered into. So OUT - IN = NET GAIN and his net gain can only come from the opportunity cost of keeping the asset for that time period (he could have sold it and invested the money at the risk-free rate).

let:

K = fair price
C = cost of capital
S = spot price of asset
F = future value of asset's dividend
I = present value of F (discounted using r )
r = risk-free interest rate compounded continuously
T = length of time from when the contract was entered into

Solving for fair price and substituting mathematics we get:

K = C + S - F \,

where:

C = S(e^{rT} - 1) \,

(since e^{rT} = 1 + j \, where j is the effective rate of interest per time period of T )

F = c_1 e^{r(T - t_1)} + \cdots + c_n e^{r(T - t_n)}

where ci is the i th dividend paid at time t i.

Doing some reduction we end up with:

K = (S - I)e^{rT}. \,

[edit] Forward versus Futures prices

There is a difference between forward and futures prices when interest rates are stochastic. This difference disappears when interest rates are deterministic.

In the language of stochastic process language, the forward price is a martingale under the forward measure, whereas the futures price is a martingale under the risk neutral measure. The forward measure and the risk neutral measure are the same when interest rates are deterministic.

See Musiela and Rutkowski's book on Martingale Methods in Financial Markets for a continuous time proof of this result. See van der Hoek and Elliott's book on Binomial Models in Finance for the discrete time version of this result.

[edit] See also

[edit] External links

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