What is Forward Price?

Explanation

This is used in a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more for enabling the physical delivery of an underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more 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 priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more with carrying costs like interest rates, expenses for storing goods, etc.

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Forward Price Formula

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 yieldDividend YieldDividend yield ratio is the ratio of a company’s current dividend to its current share price.  It represents the potential return on investment for a given stock.read more, the formula is-

Where,

  • F is the forward price of the contractS0 is the financial security’s latest spot pricee is the irrational arithmetical costsI am the P.V. (present valuePresent ValuePresent Value (PV) is the today’s value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more) of the cash incomeq is the rate of dividend yieldr is the risk-free rate of interest that is applicable for the entire term of the forward contractT is the delivery date expressed in years

Assumptions

  • 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 ratesCalculating Forward RatesThe forward rate formula deciphers the yield curve, a graphical representation of yields on different bonds with different maturity periods. Forward rate = [(1 + S1)n1 / (1 + S2)n2]1/(n1-n2) – 1read more 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 conditionArbitrage ConditionArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security’s price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more, 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.

How to Calculate?

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

  • 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 = S0erT) to find the forward rateForward RateThe forward rate refers to the expected yield or interest rate on a future bond or Forex investment or even loans/debts.read more of financial security with no income.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) erT) to find the forward rate of the financial security with known income.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.

Examples

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 RateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more = $60R 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

Forward Price vs. Future Price

The forward price must not be confused with future prices. The forward price concerns the physical delivery of an underlying financial asset, commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more, 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.

Conclusion

This is usually evaluated on the recent spot price of an underlying financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more, 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 MarketExercise PriceBond FuturesForwards vs Futures