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Forward Contract Valuation Explained

The document explains the pricing and valuation of forward contracts, detailing the no-arbitrage forward price formula and how to calculate the value of a forward contract at different times. It also covers Forward Rate Agreements (FRAs), including their structure, payoffs, and practical applications for corporations to manage interest rate risks. Examples illustrate the calculation of forward contract values and FRA payoffs based on varying market rates.

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5 views5 pages

Forward Contract Valuation Explained

The document explains the pricing and valuation of forward contracts, detailing the no-arbitrage forward price formula and how to calculate the value of a forward contract at different times. It also covers Forward Rate Agreements (FRAs), including their structure, payoffs, and practical applications for corporations to manage interest rate risks. Examples illustrate the calculation of forward contract values and FRA payoffs based on varying market rates.

Uploaded by

harsoftware3
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Derivatives

Derivatives

Pricing and Valuation of Forward Contracts


and for an Underlying with
Varying Maturities

LOS a Explain Pricing and Valuation of Forward Contracts

Forward Price and Value


With no costs of storage or benefits from holding the underlying, the
no-arbitrage forward price is:

F0(T) = S0 ×(1 + Rf)T

The no-arbitrage price is the forward price that ensures the forward
has a zero value at initiation.

© Kaplan, Inc. 2

1
LOS a Explain Pricing and Valuation of Forward Contracts

Forward Contract Value


Value of forward at time t (during contract life):

Vt(T) = St – F0(T) / (1 + Rf)(T – t)

Value of forward at settlement, t = T:

VT(T) = ST – F0(T)

© Kaplan, Inc. 3

LOS a Explain Pricing and Valuation of Forward Contracts

Example: Forward Contract Value


Long position in one-year forward contract with a price of $35, Rf = 3%.
After 9 months, spot price of underlying asset = $36. What is the value
of the forward contract?

Vt(T) = St – F0(T) / (1 + Rf)(T – t)

= $36 – $35 / (1.03)(1 – 0.75) = $1.26

© Kaplan, Inc. 4-2

2
LOS b Explain Pricing and Valuation of Forward Contracts

Forward Rate Agreement (FRA)


Exchange fixed-rate for floating-rate payment
 Notional amount (NA)
 Fixed rate = forward (contract) rate
 Floating rate (MRR) is underlying rate
At settlement:
If MRR > fixed: Long receives [MRR – fixed] × NA
If MRR < fixed: Long pays [fixed – MRR] × NA

© Kaplan, Inc. 5

LOS b Explain Pricing and Valuation of Forward Contracts

Replicating an FRA
Borrow for 90 days, starting
30 days from now

0 30 60 90 120

Replicate FRA in cash market


Borrow for 120 days

0 30 60 90 120

Lend for 30 days


© Kaplan, Inc. 6

3
LOS b Explain Pricing and Valuation of Forward Contracts

Forward Rate Agreement (FRA)


Calculate no-arbitrage forward rate for 6-month MRR 3 months from
today, F3,6, if spot 3m = 1% and spot 9m = 1.2%.

 9    3    6 
1  0.012    1  0.01   1  F3,6   
 12    12     12  

  9  
1  0.012  12   12
F3,6     1   0.013
 1  0.01 3   6
   
 12 
© Kaplan, Inc. 7

LOS b Explain Pricing and Valuation of Forward Contracts

FRA Payoffs
Given F3,6 = 1.3% and notional principal = $1mm:
If 6-month MRR 3 months from now is 1.5%
Floating-rate payer pays
1mm × (0.015 – 0.013) × 6/12 = $1,000
If 6-month MRR 3 months from now is 1.0%
Fixed-rate payer pays
1mm × (0.013 – 0.010) × 6/12 = $1,500

© Kaplan, Inc. 8

4
LOS b Explain Pricing and Valuation of Forward Contracts

FRA Uses
A corporation that expects to borrow 1mm for 6 months in three
months can fix borrowing cost with pay-fixed position in an FRA with
F3,6 = 1.3%.

A corporation that expects to lend 1mm for 6 months in three months


can fix lending rate with pay-floating position in an FRA with F3,6 =
1.3%.

© Kaplan, Inc. 9

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