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Valuing a Forward Contract Q & A

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example solution

Valuing a Forward Contract Q & A

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viickeemart
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CM2-12: Characteristics of derivative securities Page 19

Now consider the following two portfolios:

Portfolio A: Enter a forward contract to buy one unit of an asset S, with forward price K,
maturing at time T; simultaneously invest an amount Ke r T  ce r t1 in the
risk-free investment.

We are now assuming that the risk-free force of interest is constant throughout the term of the
contract so that r is appropriate for investments of term T and t1 . If this was not the case, we
would simply use two different forces of interest corresponding to the appropriate time periods.

Portfolio B: Buy one unit of the asset, at the current price S0 . At time t1 invest the
income of c in the risk-free investment.

At time t  0 the price of Portfolio A is Ke r T  ce r t1 for the risk-free investment, and zero
for the forward contract.

The price of Portfolio B is S0 .

At time t  T the payout from Portfolio A is: income of K  ce r (T t1) from the risk-free
investment; outgo of K on the forward contract. Receive 1 unit of asset, value ST . The net
portfolio at T is one unit of the asset S plus ce r (T t1) units of the risk-free security.

The payout from Portfolio B is one unit of the asset, value ST , plus ce r (T t1) units of the
risk-free security, from the invested coupon payment.

The net cashflows of Portfolio A at time T are identical to those of Portfolio B – both give a
net portfolio of one unit of the underlying asset S plus ce r (T t1) units of the risk-free
security. Using the no arbitrage assumption the prices must also be the same – that is:

Ke rT  ce  rt1  S0  K  S0e rT  ce r (T t1)

So the forward price is equal to the accumulated value at time T of the current price, less the
accumulated value at time T of the income payment, which will not be received by the buyer of
the asset under the forward contract.

Question

A fixed-interest security pays coupons of 8% pa half-yearly in arrear and is redeemable at 110%.


Two months before the next coupon is due, an investor negotiates a forward contract to buy
£60,000 nominal of the security in six months’ time. The current price of the security is £80.40
per £100 nominal and the risk-free force of interest is 5% pa.

Calculate the forward price.

Solution

Only one coupon will be received during the 6-month term of the forward contract. This will be
received in 2 months’ time and will be for amount:

0.5  0.08  60,000  £2,400

The Actuarial Education Company © IFE: 2019 Examinations


Page 20 CM2-12: Characteristics of derivative securities

So, using the formula derived above, the forward price is equal to:

60,000 0.056/12
K  80.4  e  2,400e0.05(6/122/12)  £47,021
100

For a long forward contract on a fixed-interest security there may be more than one coupon
payment. It is easy to adapt the above method to allow for this. If we let I denote the
present value at time t  0 of the fixed income payments due during the term of the forward
contract, then the forward price at time t  0 per unit of security S is

K  (S0  I )e rT

The word ‘long’ here is being used to say that the term is long, rather than being a reference to a
‘long forward position’ (ie agreeing to purchase the asset under the forward contract).

So, in this case, the forward price is equal to the current price, less the present value at time 0 of
the income payments during the term of the contract, accumulated to time T . This formula
appears on page 45 of the Tables, where the forward price is denoted by F rather than K .

Question

Consider the scenario in the previous question.

On the same day, a different investor negotiates a forward contract to purchase £50,000 nominal
of the security in ten months’ time.

Calculate the forward price of this contract.

Solution

Two coupons will be received during the 10-month term of this forward contract: one in 2
months’ time and another in 8 months’ time. The amount of each coupon will be:

0.5  0.08  50,000  £2,000 .

So, using the formula given above:


K   80.4 

50,000
100
  
 2,000 e 0.052/12  e 0.058/12  e0.0510/12  £37,826

As well as being used to calculate the forward price for contracts based on fixed-interest
securities (which have known coupon payments), the formula above can also be used to calculate
the forward price for contracts based on shares where the dividend payments to be received
during the term of the contract are known in monetary terms. In this case, I would be equal to
the present value of the dividends received during the term of the contract.

© IFE: 2019 Examinations The Actuarial Education Company

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