8.2 Pricing and Valuation of Forward Commitments - 8.2 Pricing and Valuation of Forward Commitments

Key Concepts

• Forward Contracts
• Futures Contracts
• Forward Price
• Futures Price
• Spot Price
• Cost of Carry
• Marking to Market

Forward Contracts

A Forward Contract is an agreement between two parties to buy or sell an asset at a specified future date for a predetermined price. Unlike futures contracts, forward contracts are not standardized and are traded over-the-counter (OTC). They are typically used for hedging or speculation.

Example: A farmer and a cereal company agree that the company will buy 1,000 bushels of wheat from the farmer at $5 per bushel in six months. This is a forward contract where the price and delivery date are fixed.

Futures Contracts

Futures Contracts are similar to forward contracts but are standardized and traded on organized exchanges. They require the parties to settle the contract daily through a process called marking to market. Futures contracts are widely used for hedging and speculation.

Example: An investor buys a futures contract on crude oil that specifies delivery of 1,000 barrels at $70 per barrel in three months. The contract is standardized with specific terms and is traded on an exchange.

Forward Price

The Forward Price is the predetermined price at which the asset will be bought or sold in a forward contract. It is determined by the spot price of the asset, the cost of carry, and the time to maturity. The forward price ensures that no arbitrage opportunities exist.

Example: If the spot price of gold is $1,800 per ounce, the cost of carry (including storage and interest) is $50 per ounce, and the time to maturity is one year, the forward price would be $1,850 per ounce.

Futures Price

The Futures Price is the predetermined price at which the asset will be bought or sold in a futures contract. It is similar to the forward price but is influenced by factors such as daily marking to market and the liquidity provided by the exchange.

Example: If the spot price of soybeans is $10 per bushel, the cost of carry is $1 per bushel, and the time to maturity is six months, the futures price would be $11 per bushel, adjusted for daily settlement.

Spot Price

The Spot Price is the current market price at which an asset can be bought or sold for immediate delivery. It is a key component in determining the forward and futures prices, as these prices are derived from the spot price and the cost of carry.

Example: If the spot price of a stock is $50, this is the price at which the stock can be bought or sold immediately. The forward or futures price for delivery in the future will be based on this spot price.

Cost of Carry

The Cost of Carry includes all costs associated with holding an asset until the forward or futures contract matures. These costs typically include storage costs, insurance, and the opportunity cost of capital. The cost of carry affects the forward and futures prices.

Example: If holding a barrel of crude oil incurs storage costs of $2 per month and an opportunity cost of $1 per month, the total cost of carry for six months would be $18 per barrel, which would be reflected in the forward or futures price.

Marking to Market

Marking to Market is the process by which the value of a futures contract is adjusted daily to reflect the current market price. This ensures that both parties to the contract are protected from potential losses and that the contract reflects current market conditions.

Example: If an investor holds a futures contract on corn that was initially priced at $4 per bushel and the market price drops to $3.50, the investor's account will be debited by the difference of $0.50 per bushel to reflect the current market value.