Introduction

In the realm of financial derivatives, forward contracts play a pivotal role in managing risks and speculating on future asset prices. Understanding the value of a forward contract is crucial for investors and traders to make informed decisions. This chapter delves into the intricacies of calculating the value of forward contracts, considering scenarios where the underlying asset may or may not provide income or yield.

Value of a Forward Contract

Calculating the Value of a Forward Contract

The value of a forward contract represents the potential gain or loss that can be accrued by holding the contract until maturity. It takes into account the difference between the forward price and the current spot price of the underlying asset.

Assets with No Income or Yield

When dealing with an asset that does not provide income or yield, the value of a forward contract is primarily determined by the difference between the current spot price and the agreed-upon forward price. This straightforward calculation gives a clear picture of the contract’s potential value at expiration.

Example: Consider a forward contract on gold. The current spot price of gold is $1500 per ounce, and the forward price for delivery in six months is $1600 per ounce. The value of the forward contract can be calculated as $1600 - $1500 = $100 per ounce.

Assets with Income or Yield

For assets that do provide income or yield, such as dividend-paying stocks or interest-bearing bonds, the calculation of the forward contract’s value becomes more nuanced. The value now includes the present value of the income or yield generated over the life of the contract.

Example: Let’s say you’re analyzing a forward contract on a dividend-paying stock. The current spot price is USD 50, and the forward price is USD 55. Additionally, the stock is expected to pay a USD 2 dividend in three months. Assuming a risk-free interest rate of 4% per annum, the value of the forward contract can be calculated as follows:

• Present Value of Dividend = USD 2 / (1 + 0.04)^(3/12) ≈ USD 1.98
• Value of Forward Contract = (USD 55 - USD 50) + USD 1.98 = USD 6.98

Importance of Yield and Interest Rates

The inclusion of income or yield in the value calculation underscores the impact of interest rates. Higher interest rates can lead to a decrease in the present value of future cash flows, affecting the overall value of the forward contract.