A:

Forward contracts are buy/sell agreements that specify the exchange of a specific asset and on a specific future date but on a price that is agreed upon today. They do not require early payment or down payment unlike some other future commitment derivative instruments. Since no money changes hands at the initial agreement, no value can be attributed to it. In other words, the forward price is equal to the delivery price.

Mathematics of Forward Contract Valuation

Derivative valuation is not an exact science, and it is a subject of serious philosophical and methodological deviation between financial economists, security engineers and market mathematicians. The most common treatment of forward contracts begins with the assumed observation that forward contracts can be stored at zero cost. If a security can be stored at zero cost, then the forward price for delivery of the security is equal to the spot price divided by the discount factor.

You may see this expressed as: F = S / d(0,T), where (F) is equal to the forward price, (S) is the current spot price of the underlying asset, and d(0,T) is the discount factor for the time variable between the initial date and the delivery date.

This might seem complicated and technical, which it is; the discount factor depends on the length of the forward contract. Mathematically, this is demonstrated as an equilibrium price because any forward price above or below this value represents an arbitrage opportunity.

Forward Price and Forward Value

At a date where (T) is equal to zero, the value of the forward contract is also zero. This creates two different but important values for the forward contract: forward price and forward value. Forward price always refers to the dollar price of assets as specified in the contract. This figure is fixed for every time period between the initial signing and the delivery date. The forward value begins at storage cost and tends toward the forward price as the contract approaches maturity.

Exchange Logic and Initial Value

What is the initial value of a $300,000 mortgage contract that requires a 15% down payment? Simple economic logic suggests the initial contract value is $45,000, or 0.15 x $300,000. That is how much money the lender demands to establish the contract. The borrower also agrees to part with $45,000 to receive the initial contract.

Carry this logic to forward contracts. The vast majority of forward contracts carry no down payment. If both parties are willing to exchange their commitment to the contract for $0.00, then it follows that the initial value of the contract is zero.

These explanations are incomplete, because they ignore many of the factors associated with mortgage and forward contracts, namely the underlying assets. However, in a strict economic sense, these arguments are valid as far as they go.

RELATED FAQS
  1. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
  2. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
  3. How does a forward contract differ from a call option? (AAPL)

    Find out more about forward contracts, call options, the mechanics of these financial instruments and the difference between ... Read Answer >>
  4. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  5. What is the difference between options and futures?

    An option gives a buyer the right, but not the obligation to buy or sell an asset, A futures contract obligates the buyer ... Read Answer >>
Related Articles
  1. Investing

    How to Trade Futures Contracts

    Futures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
  2. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  3. Trading

    Futures Fundamentals

    This tutorial explains what futures contracts are, how they work and why investors use them.
  4. Investing

    Investing in Crude Oil Futures: The Risks and Rewards

    Learn about the risks and rewards of trading oil futures contracts. Read about a few strategies to limit the risk in trading oil futures contracts.
  5. Investing

    What is a Forward Rate?

    Forward rate is used in both bond and currency trading to represent the current expectations of future bond interest rates or currency exchange rates.
  6. Trading

    An Introduction To Trading Forex Futures

    We explain what forex futures are, where they are traded, and the tools you need to successfully trade these derivatives.
  7. Investing

    Is USO a Good Way to Invest in Oil?

    The United States Oil Fund is better suited to short-term investors who actively manage their portfolios.
RELATED TERMS
  1. Short Date Forward

    A short date forward is an exchange contract involving parties ...
  2. Forward Market

    A forward market is an over-the-counter marketplace that sets ...
  3. Forward Discount

    A forward discount occurs when the expected future price of a ...
  4. Forward Commitment

    A forward commitment is an agreement between two parties to carry ...
  5. Fixed Income Forward

    A fixed income forward is a contract between two parties to either ...
  6. Forward Spread

    A forward spread is the price difference between the spot price ...
Trading Center