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Forward Pricing

Reviewed by Vineeth | Updated on Sep 30, 2020

Catalogue

Introduction

The forward price is defined as the predetermined delivery price for currency, commodity, or any financial asset as agreed by the seller and buyer involved in the forward contract, which will be paid at a time in the future which is predetermined.

At the time of documentation of the forward contracts, the forward price will make the contract value zero. However, fluctuations in the price of the asset or currency in the contract will make the forward to either take a negative or positive value.

Formula to Calculate Forward Price

The forward price can be calculated using the following formula: * F0=S0(e)^rT *

The terms in the formula are explained below: F is the forward price of the contract S is the spot price of the underlying asset e is an approximated mathematical constant r is the risk-free rate of the forward contract, and T is the date of delivery in years.

Understanding the Fundamentals of Forward Price

A forward price is arrived at by considering the current spot price of the asset, which is underlying in the contract. Furthermore, carrying charges, such as interest, forgone interest, storage costs, and other costs are also accounted for when arriving at the forward price.

Despite the forward contracts not having an intrinsic value at the time of the agreement, they may gain or lose value depending on a lot of factors with time. Offsetting of positions in forward contracts is comparable with someone's loss or someone's gain theory.

For instance, if an investor holds a long position in one of the pork belly agreements and another investor holds a short position, then gains resulting from the long position will be equal to the losses arising to the investor holding the short position.

By setting the initial value of the contract to zero, both the parties of the contract are on the same level at the time of the agreement.

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