Forward Price

Forward price can be defined as a forecasted delivery price of an underlying financial asset; in other words, it is a price at which a supplier delivers an underlying financial asset or commodity to the customer of a forward contract, and it is entirely based upon the spot price of an underlying financial asset that includes carrying costs like foregone costs, interest, etc.

When the parties enter into the contract, it does not have any intrinsic value. However, during expiry, the value may increase or decrease for either party. This is due to the fact that markets are not always stable, and the price of the underlying asset, which in this case may be a commodity, stock, bonds, indices, etc, may change.

This is used in a forward contract for enabling the physical delivery of an underlying asset or a commodity. The seller pays the price to the customer of the forward contract at a pre-decided period against the delivery of an underlying asset or item. It can be calculated by adding up the spot price with carrying costs like interest rates, expenses for storing goods, etc.

The price of the forward contract will not change but the profit or loss of the parties will depend on the market condition at the time when the contract will be exercised. It, however, takes into consideration various factors like the opportunity cost of not opting for the price at the time of exercising the contract, the current market price of the financial product or instrument, which is the underlying asset, along with its associated cost and any interest rate. Since market conditions may be subject to volatility and sudden changes, the value of the contract may prove to be either positive of negative for any of the parties.

The formulas used for calculating the forward price of financial security depend on whether it has no income, known cash income, or known dividend yield. The formulas used for the determination of financial security in each case are:

With no income is, it is -

With known cash income, the formula is-

With known dividend yield, the formula is-

Where,

• F is the forward price of the contract
• S₀ is the financial security’s latest spot price
• e is the irrational arithmetical costs
• I am the P.V. (present value) of the cash income
• q is the rate of dividend yield
• r is the risk-free rate of interest that is applicable for the entire term of the forward contract
• T is the delivery date expressed in years

• Forward rates are calculated on a “no arbitrage” assumption. Arbitrage is a mechanism that enables trading profits to be entirely from risks. So, calculating forward rates on a no-arbitrage assumption will mean that the profits earned by the traders will not be free from any risk.
• This assumption is merely because the financial securities are simultaneously traded, i.e., purchased and sold. Another reason for calculating forward rates based on a "no arbitrage" assumption is that the occurrence of arbitrage is rare in a developed security exchange market.
• However, whenever arbitrage opportunities arise in a financial security exchange market, the investors can readily identify and eliminate the same to derive maximum advantages from such a scenario. In a no-arbitrage condition, only two portfolios that result in duplicate payments can be equally priced. The equal pricing of these two portfolios or financial securities can be used to evaluate the rate.

It can be calculated for each scenario using the following steps-

1. Steps to follow when there is no income -
   • In the first step, the users will need to identify the financial security’s ongoing spot price (S₀ )
   • In the next step, the users will need to identify the irrational arithmetical costs (e)
   • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
   • The users will need to take all the values and place them in the formula (F = S₀e^rT) to find the forward rate of financial security with no income.
2. Steps to following when there is known income -
   • In the first step, the users will need to identify the financial security’s ongoing spot price (S₀ )
   • In the next step, the users will need to identify the P.V. of the cash income (I)
   • Next, the users will need to identify the irrational arithmetical costs (e)
   • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
   • The users will need to take all the values and place them in the formula (F = (S₀ – I) e^rT) to find the forward rate of the financial security with known income.
3. Steps to follow when there is dividend yield -
   • In the first step, the users will need to identify the financial security’s ongoing spot price (S₀ )
   • In the next step, the users will need to identify the rate of dividend yield (q)
   • Next, the users will need to identify the irrational arithmetical costs (e)
   • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
   • The users will need to take all the values and place them in the formula (F = S₀e^(r-q)T) to find the forward rate of the financial security with known dividend yield.

A Limited and B Limited entered into a 5-month forward contract to trade a bond at $60. The five-month risk-free interest rate on this bond is 6 percent per annum.

Solution:

• S₀ or Spot Rate = $60
• R or risk-free rate of interest = 6 % p.a.
• T or the maturity term = 5 months or 0.417.

• = 60 * e ^{(0.06 * 0.417)}
• = 60 * 1.025336
• = $61.52

Therefore, the FP is $61.52

The forward price must not be confused with future prices. The forward price concerns the physical delivery of an underlying financial asset, commodity, security, or currency. In contrast, future prices can be defined as the price of a commodity or stock in a futures contract. Forward price represents the supply and demand for a particular commodity type, whereas future price represents the international supply and demand.

This is usually evaluated on the recent spot price of an underlying financial asset, commodity, security, or currency, including carrying costs that may include storage, foregone interest, rate of interest, opportunity costs, etc.

This has been a guide to What forward price is & its Definition. Here we discuss calculating the forward price step-by-step by using formulas, examples, and assumptions. You can learn more about it from the following articles –

• Forward Market
• Exercise Price
• Bond Futures
• Forwards vs Futures