Derivative Investments【Reading 54】Sample forward, price, contract, 2012

JoeyDVivre

The price of a forward contract:

A) is the settlement price for the underlying asset.

B) must be equal to the market price at contract termination.

C) is equal to the value of the contract in equilibrium.

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The price of a forward contract is the price of the underlying asset that the long will pay to the short at settlement (for a deliverable contract). The value of a forward contract comes from the difference between the forward contract price and the market price for the underlying asset. This difference between price and value is a key concept to understand. A forward contract has only one price, which applies to both the long and to the short.

JoeyDVivre

The theoretical price of a forward contract:

A) equals the long’s expectation of the future price of the underlying asset.

B) is always greater than the current price of the underlying asset.

C) is the no-arbitrage price.

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The theoretical price of a forward contract is the future price of the underlying asset imposed by the no-arbitrage conditions. It can be less than the current price of the asset if the cost-of-carry is negative. Accrued interest is paid by the long at delivery under a bond forward, but is not included in the price quote, which is usually in terms of yield to maturity at the settlement date.

JoeyDVivre

Which of the following best describes the price of a forward contract? The forward price is:

A) the price that makes the values of the long and short positions zero at contract initiation.

B) always equal to the market price at contract termination.

C) always expressed in dollars.

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The forward price is the contract price of the underlying asset under the terms of the forward contract, and is the price that makes the values of the long and short positions zero at contract initiation. It is not the amount it costs to purchase the forward contract. The forward price is expressed in terms of the underlying asset, and may be a dollar value, exchange rate, or interest rate. The value of a forward contract comes from the difference between the forward contract price and the market price for the underlying asset. These values are likely to be different at contract termination, which will result in a profit for either the long or the short position.

JoeyDVivre

The price of a forward contract:

A) changes over the term of the contract.

B) depends on forward interest rates.

C) is determined at contract initiation.

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The price of a forward contract is established at the initiation of the contract and is expressed in different terms, depending on the underlying assets. It is the price that makes the contract value zero, and depends on current interest rates through the cost-of-carry calculation.

JoeyDVivre

At expiration, the value of a forward contract is:

A) the difference between the contract price and the market value of the underlying asset.

B) equal to the market price of the underlying asset.

C) always greater than or equal to zero.

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In a forward contract, the long is obligated to buy, and the short is obligated to sell, the underlying asset at the contract price. The difference between the contract price and the market price of the asset is what gives the contract value. The contract has a positive value at expiration to the long/short only if the contract price is below/above the market price.

JoeyDVivre

At contract initiation, the value of a forward contract:

A) depends on the market price of the underlying asset.

B) is typically zero regardless of the price of the underlying asset.

C) is set to 100 by convention.

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Due to the no-arbitrage principle, the price of a forward contract is calculated to make the value of the contract zero at contract initiation. Neither the long nor the short typically makes any payment to enter into the forward agreement. A special case is an off-market forward where, for whatever reason, the contract price is not set equal to the no-arbitrage price, and the long or short position makes a payment to the opposite counterparty to offset the difference.

JoeyDVivre

During the life of a forward contract, the value of the contract is best described as:

A) the difference between the future value of the spot price and the expected future price of the underlying asset.

B) the difference between the spot price and the present value of the forward price of the underlying asset.

C) the present value of the expected future price of the underlying asset.

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The value of a forward contract on an asset with no cash flows during its term is equal to spot − (forward price) / (1 + Rf)t), the difference between the spot price and the present value of the forward price of the underlying asset.

JoeyDVivre

The contract price of a forward contract is:

A) always the present value of the expected future spot price.

B) determined at the settlement date.

C) the price that makes the contract a zero-value investment at initiation.

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The contract price can be an interest rate, discount, yield to maturity, or exchange rate. The forward price is the future value of the spot price adjusted for any periodic payments expected from the asset. An example of when the forward price may be less than the spot price is in the case of an equity index contract where the dividend yield is greater than the risk-free rate.

JoeyDVivre

The forward price in a 90-day forward contract on a non-dividend-paying stock currently (at contract initiation) selling for $55 when the 90-day risk-free rate is 5% is closest to:

A) $55.67.

B) $54.32.

C) $52.38.

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JoeyDVivre

A portfolio manager holds 100,000 shares of IPRD Company (which is trading today for $9 per share) for a client. The client informs the manager that he would like to liquidate the position on the last day of the quarter, which is 2 months from today. To hedge against a possible decline in price during the next two months, the manager enters into a forward contract to sell the IPRD shares in 2 months. The risk-free rate is 2.5%, and no dividends are expected to be received during this time. However, IPRD has a historical dividend yield of 3.5%. The forward price on this contract is closest to:

A) $905,175.

B) $901,494.

C) $903,712.

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The historical dividend yield is irrelevant for calculating the no-arbitrage forward price because no dividends are expected to be paid during the life of the forward contract. In the absence of an arbitrage opportunity, the value of should be 0.
Therefore, FP = S0(1 + Rf)T
903,712 = 900,000(1.025)2/12