Forward Price Vs value of a Forward Contract
We will cover following topics
Introduction
In the realm of financial derivatives, it is crucial to distinguish between the forward price of an asset and the value of a forward contract associated with that asset. These concepts, while related, have distinct implications and applications in the world of investing and risk management. This chapter delves into the differences between the forward price and the value of a forward contract, shedding light on their individual characteristics and significance.
Forward Price and Value
Forward Price
The forward price of an asset refers to the anticipated price at which a buyer and seller agree to transact the asset on a future date. It’s a price determined today for a future delivery. The forward price incorporates various factors such as the current spot price of the asset, the cost of carry (including financing costs, storage costs, and dividends or yields for income-generating assets), and the time until the contract’s maturity.
For example, if an investor wishes to enter a forward contract to buy 100 barrels of crude oil in six months, the forward price will be influenced by the current spot price of crude oil, the storage and financing costs associated with holding the oil, and any expected dividends or yields.
Value of a Forward Contract
The value of a forward contract, on the other hand, is the current worth of the rights and obligations embedded in the contract. It represents the potential monetary gain or loss that could result from holding the contract until expiration. The value of a forward contract is affected by changes in the underlying asset’s spot price and the passage of time.
To illustrate, consider an investor who holds a forward contract to buy shares of a company’s stock at a predetermined price in six months. If the stock’s price increases before the contract matures, the value of the forward contract also increases, as the contract becomes more favorable compared to the current market price. Conversely, if the stock’s price decreases, the value of the forward contract decreases.
Conclusion
In essence, while the forward price establishes the agreed-upon future transaction price for an asset, the value of a forward contract reflects the current monetary worth of holding that contract until expiration. Understanding the distinction between these two concepts is vital for investors and traders seeking to manage risk and capitalize on potential market movements. By comprehending how the forward price and the value of a forward contract are determined, market participants can make informed decisions and strategically position themselves in the dynamic world of financial derivatives.