Forwards Futures

Section: Forwards and Futures Estimated study time: 45 minutes Content: A forward contract is a private, customized agreement between two parties to buy or sell an asset at a specified future date (delivery date) at a price agreed upon today (the forward price). The party obligated to buy the asset holds the long position; the party obligated to sell holds the short position. Forward contracts are OTC (over-the-counter) instruments: flexible, customized, but carrying counterparty risk (the risk that the other party defaults before settlement). At expiration, the payoff to the long is: ST – F0, where ST is the spot price at expiration and F0 is the forward price agreed at initiation. If the underlying's price has risen above F0, the long profits; if below F0, the short profits. No cash is exchanged at initiation — the contract has zero value initially. The no-arbitrage forward price for an asset with no income and no storage costs is: F0 = S0 × (1 + r)^T, where S0 is the current spot price, r is the risk-free rate, and T is the time to expiration in years. This formula reflects the cost of carry: the forward price must equal what it would cost to buy and hold the asset today until delivery. If F0 > S0 × (1 + r)^T, arbitrageurs sell the forward and buy the asset (financing at r), locking in a riskless profit. For assets with continuous income yield (dividends or foreign interest), the forward price is: F0 = S0 × e^((r–q)T) in continuous compounding notation. For commodity forwards, storage costs and convenience yield affect pricing: F0 = S0 × e^((r + storage cost – convenience yield)T). These…