Question

Assume that there is a forward market for a commodity. The forward price of the commodity is $45. The contract expires in one year. The risk-free rate is 10%. Now 6 months later, the spot price is $52.

What is the forward contract worth at this time? Explain why this is the correct value of the forward contract in 6 months even though the contract does not have a liquid market as a futures contract does.

Answer 1

The value of the forward contract is the spot price of the underlying asset minus the present value of the forward price.

Vt(T) = St – F0(T) (1+r) ^-(T-t)

= 52 - 45 (1 + 10%) ^{- (1 - 0.5)}

Value of forward contract after 6 months = $9.09

This is the correct value of the forward contract in 6 months. Forward contracts are customized contract between parties and are not traded on stock exchanges and hence are not as liquid as futures. Futures contract on the other hand are listed on exchanges and their value can be determined at any point due to computerized trading platform.