Topic 3: Forwards and Forward Pricing

Willem J. van Vliet

FINA4110 Options and Futures

Chinese University of Hong Kong

2024 Term 1

1
Roadmap

Introduce you to forwards (mostly)

Pricing forwards
▶ Investment assets

⋆ Without any income or costs

⋆ In the presence of income (such as dividends)
⋆ In the presence of storage costs (such as for commodities)
▶ Consumption assets

Valuing forwards

2
Forward Contract

A forward contract is a contract to buy a specied underlying asset

at a specied delivery date at a specied forward price.
(At least in theory:) No cash is exchanged in advance.
▶ This is just a contract to buy the asset at the delivery date at the

forward price.
▶ This isn't quite true, but let's wait until we have talked about futures.

The party that will buy the asset (and pay the forward price) is said to
have a long position or be long.

The party that will sell the asset (and receive the forward price) is said
to have a short position or be short.

3
Forward Contract

These are completely customizable contracts.

Trade in over-the-counter markets.

They are usually held until the delivery date, when delivery takes place
(the underlying asset is exchanged for the forward price).

4
Underlying Assets

The underlying assets are typically classied as:

▶ Investment asset: an asset held primarily for investment purposes
(held for cash ows and price changes)
⋆ (Foreign) Currency
⋆ Stocks, bonds, nancial assets
⋆ Interest rates (interest payments)
⋆ Another derivative contract
⋆ Some commodities like gold
▶ Consumption asset: an asset held primarily for consumption (that is,
it's going to be used)
⋆ Agricultural commodities
⋆ Energy commodities
⋆ Metals (possibly with the exception of gold)

5
Example

A contract to buy ¿1,000,000 on September 10, 2025 at a price of

8.47HKD/ ¿.
▶ Underlying asset: ¿1,000,000
▶ Delivery date: September 10, 2025

▶ Forward price: 8.47HKD/ ¿

This means that next year on September 10:
▶ The long party will pay HK$8,470,000 to the short party and receive

¿1,000,000 from them.

▶ The short party will deliver ¿1,000,000 to the long party and receive
HK$8,470,000 from them.

(Side note: the forward prices of FX forwards are typically not quoted
this way. They are typically quoted in forward points which are
1/10,000 changes to the spot exchange rate. In this example, if the
spot exchange rate is 8.38HKD/ ¿, then this forward contract would
be quoted as +900 indicating that the forward price is 900/10,000 =
0.09 above the spot exchange rate.)
6
Purpose

Forward contracts are primarily used for hedging: using an investment

to reduce one's existing (nancial) exposure to uncertainty.

Can also be used for speculating (which means to increase one's

exposure), but this is rare as forwards typically lead to delivery of the
underlying asset.
▶ Speculators typically do not want to deal with buying or selling the

underlying asset.
▶ Futures (which we will cover later) tend to be more appropriate for

speculating.

7
Example

For example: your rm will receive ¿1,000,000 in one year but you are
based in Hong Kong and really care about how many HKD you will
get.

You are exposed to exchange rate risk

▶ If the Hong Kong dollar appreciates relative to the Euro, then you will

get less HKD in one year when you exchange it.

You can hedge this buy going short the previous HKD for Euro
forward contract on ¿1,000,000.
▶ Remember that no cash is exchanged today in a forward contract (not

quite, but almost correct).

▶ In one year, you get ¿1,000,000, but as the short party you deliver
¿1,000,000 and receive HK$8,470,000, regardless of what the
exchange rate actually is.

8
Pricing

For forward contracts, pricing means calculating the fair forward price.
▶ Remember: in a forward contract, no cash is exchanged today. The

forward price is paid at the delivery date in exchange for the underlying
asset.

This is a little dierent from other things you may have priced in the
past where you are typically trying to nd the fair spot price (price
paid today).

9
Assumptions

There are no transaction costs

▶ No costs to transact in the asset, such as brokerage fees, bid-ask

spreads, and fees for short selling

Taxes are irrelevant

▶ Either no taxes, or tax treatment of investments with the same payos

is equal

Market participants can borrow and lend freely at the risk-free rate

Prices are set so that there are no arbitrage opportunities

10
Notation

t is time
▶ 0 is today
▶ T >0 is the delivery date of the forward/futures contract

Ft is the forward price at time t (for a contract with delivery date T)

St is the spot price of the underlying asset at time t

r is the time t=0 (today) risk-free zero rate at maturity T

11
Cash Flows

Just to help you get familiar with the notation, note that the forward
contract has the following cash ow

At time t = 0, it costs 0 and pays o 0, so the cash ow is 0

At time t=T (the delivery date), the long party pays F0 and receives
an asset worth ST . Therefore the cash ow to the long party is

ST − F0

Note that from the time t=0 perspective, ST is risky (uncertain)

while F0 is riskless (certain) as it was agreed upon at time 0

12
Arbitrage

An arbitrage opportunity (in the academic sense) is a trade or

sequence of trades that:
▶ never costs you anything (you never have to put in any of your own

money), and
▶ with positive probability leads to a positive payo.

This is essentially free money. If you nd such a thing, you would
trade as much as you can.

In this class we will assume that prices are set so that there are no
arbitrage opportunities. This is called no arbitrage pricing.

13
Forward Price: Simplest Case

We start with the simplest case:

▶ Investment asset
▶ Asset has no intermediate payos (no dividends, no coupons, no other

sources of income) before T

▶ No costs to store the asset

Then, I claim by no arbitrage that the forward price is

F0 = e rT S0

14
Proof Using No Arbitrage

Suppose F0 > e rT S0 . We will show that this creates an arbitrage

opportunity.

Do the following today:

▶ Sell the forward contract
▶ Borrow S0 dollars at the risk-free rate
▶ Buy the underlying asset

And do the following at T (the delivery date)

▶ Deliver the asset as part of the forward contract, for which you get F0
▶ Repay your loan plus interest: e rT S0

This is an arbitrage
▶ Costs nothing today
▶ Generates a guaranteed prot of F0 − e rT S0 > 0 at time T

15
Proof Using No Arbitrage

Now suppose F0 < e rT S0 . We will show that this also creates an

arbitrage opportunity.

Do the following today:

▶ Buy the forward contract
▶ Short-sell the asset, which generates S0 in cash
▶ Save the S0 dollars at the risk-free rate

And do the following at T (the delivery date)

▶ Use F0 dollars from your savings to take delivery of the asset from your
forward contract
▶ Return the asset to your lender

This is an arbitrage
▶ Costs nothing today
▶ Generates a guaranteed prot of e rT S0 − F0 > 0 at time T

16
Proof Using No Arbitrage

F0 > e rT S0 ⇒ arbitrage
▶ Short the forward contract, go long the asset with borrowed cash

F0 < e rT S0 ⇒ arbitrage
▶ Long the forward contract, short-sell the asset and save the cash

The only price that does not create an arbitrage is F0 = e rT S0

▶ Try what you like, any combination of the forward, the asset, and

risk-free borrowing/savings that costs nothing today will not lead to

any guaranteed prots

17
Alternative Argument

Buying a forward contract at price F0 gives you:

▶ 0 today
▶ ST − F0 at time T

Now, consider the following transaction. Borrow S0 today (promising

to repay at T ), and use it to buy the asset today
▶ Borrow S0 and immediately buy something at price S0 today, so net 0
today
▶ At time T , you have an asset worth ST and owe e rT S0 , so net
rT
ST − e S0

Identical cash ows today (0)

Similar structure at time T

▶ ST − F0 from forward
▶ ST − e rT S0 from buying the asset with borrowed funds

Same risky part (ST ), need to have the same risk-free parts (F0 vs.
e rT S0 ) in order not to generate arbitrage opportunities
18
Understanding the Price

The forward price F0 = e rT S0 is today's price for the asset (S0 ) moved
forward at the risk-free rate r . That is, it is the time-T future value of
today's price S0 .

Let rA denote the expected return on the asset. That is:

expected value of ST = E [ST ] = e rA T S0

Shouldn't the price be e rA T S0 , the expected price?

There are three dierent ways to see that is not right.

19
Understanding the Price: 1

Remember this is an investment asset that does not generate income

and has no costs. Getting the asset now or knowing you will get it at
time T are therefore the same to you.

Compared to buying the asset today, the forward is merely delaying

timing of the payment
▶ Buy today: pay S0 , get the asset
▶ Buy forward: pay F0 at time T , get the asset at time T

Either way, you pay a xed amount (either S0 today or F0 at T ), and

end up with the asset.

We are just moving a risk-free payment through time, and we do that

at the risk-free rate r, not the expected return on the asset rA .

20
Understanding the Price: 2

This is a dierent way of saying the same thing: the expected return
on the asset is compensation for time and risk
▶ Buy it today, pay S0 today and take on any risk in the asset
▶ If we wait, we pay later and can choose whether or not to even buy it.

rA compensates not only the earlier timing of the payment, but also
that we end up bearing additional risk

The forward contract will force you to buy the asset anyway. You are
going to bear the risk of the asset regardless
▶ Buy it today, exposed to ST
▶ Buy it through the forward, you will end up with an asset worth ST .
Same risk exposure.

The forward does not change the risk, just the timing of the payment,
so the relevant discount rate is the risk-free rate

21
Understanding the Price: 3

This is a third way of saying the same thing

A forward at price F0 has time-T payo

ST − F0
(You get an asset worth ST in return for a xed payment of F0 )

ST is risky, so we discount that to today at some risk-adjusted rate rA

to get today's price S0

F0 is xed (risk-free), so we discount that to today at the risk-free

rate r to get today's value e −rT F0

The present value of this transaction is therefore

S0 − e −rT F0
Any gains for one party are a loss for the other, so this has to be zero
22
Even More Intuition

Suppose the expected return on the asset rA > r . We call this a risk
premium, meaning you need to be compensated with an additional
expected return to take on the risk of the asset
▶ Put dierently, the stock is cheaper today to compensate for the risk

This means that the price today S0 is below the expected value of ST
discounted at risk-free rates

The forward contract carries the same risk as owning the asset
outright: either way you are exposed to the price of the asset

With the forward contract, you are being compensated for this risk by
locking in a cheaper price

F0 = e rT S0 < e rA T S0 = expected price at T

23
Numerical Intuition

The price right now of the asset is S0 = $100

One-year risk-free rate is 1% per annum

Expected value of the asset in one year is $110

▶ 10% expected return is compensation for risk
▶ You pay just $100 to get an expected $110 next year

The fair forward price is $101 < $110

▶ The cheap price again represents compensation for risk

24
Even More Intuition

Suppose the expected return on the asset rA < r . This means there is
a negative risk premium, meaning you like the risk that the asset
provides and so are willing to pay to be exposed to it
▶ Put dierently, the stock is more expensive today because it provides

you the risk you like

The value S0 is above the expected value of ST discounted at risk-free

rates

The forward contract still carries the same risk as owning the asset
outright

With the forward contract, you are paying to take on this risk by
locking in a higher price

F0 = e rT S0 > e rA T S0 = expected price at T

25
No Arbitrage and Equilibrium

It's important to remember that

F0 = e rT S0

came from a no-arbitrage argument

F0 < e rT S0 creates an arbitrage that would cause buying pressure on

the forward (and selling on the asset), raising F0 and lowering S0 until
we reach this relationship

F0 > e rT S0 creates an arbitrage that would cause selling pressure on

the forward (and buying of the asset), lowering F0 and raising S0 until
we reach this relationship

Also important to remember that our pricing argument is a

no-arbitrage argument: the intuition with expected returns is just
intuition

26
Example: Stock Forward Without Dividend

A stock sells today for $150. You know for certain that it will not pay
out any dividends over the coming year

The one-year zero rate is 4% p.a. with continuous compounding

The one-year forward price on the stock is

F0 = e 0.04×1 × $150 = $156.12

27
No Short-Sales

A valid question is What if the underlying asset is impossible/dicult

to short sell?
▶ Our argument for why F0 > e rT S0 creates an arbitrage would be
unaected, as this involves buying the asset
▶ Our argument for why F0 < e rT S0 creates an arbitrage involved
short-selling the asset, which we are now saying we cannot do

In that case, is the best we can do to say that F0 ≤ e rT S0 ?

28
No Short-Sales

Typically, no. We can still claim that F0 = e rT S0 without the

inequality

Why? Somebody out there owns the asset.

If F0 < e rT S0 , someone with the asset would

▶ Sell the asset at S0 , and save the cash at the risk-free rate
▶ Buy a forward contract

At time T, they would pay F0 from their e rT S0 to regain the asset

Compared to doing nothing and holding onto the asset, they have an
extra, risk-free e rT S0 − F0 > 0 in savings at no cost them

29
Relaxing the Assumptions

So far, we have the price

F0 = e rT S0

but this requires that there is no dierence between:

▶ Getting the asset now and holding on to it until time T
▶ Knowing that you will receive the asset at time T

In real life, there are some sources of dierences:

▶ The asset may generate income

▶ The asset may be costly to hold/store

▶ The asset may provide consumption benets

We can adjust the forward pricing formula for each of these cases

30
Income

Suppose the asset generates income with present value I between now
and time T

Even with F0 = e rT S0 , this would create an arbitrage opportunity:

▶ Sell the forward
▶ Borrow S0 and buy the asset at price S0

Looks ne:
▶ Today: net 0 (borrow and spend S0 )
▶ Time T: net 0 (deliver asset, get F0 = e rT S0 but repay loan e rT S0 )

The problem is that between time 0 and T, we own the asset, so we

earn I!
▶ This is a trading strategy that costs nothing today, nothing at time T,
and earns a positive prot of I in between

31
Adjusting for Income

As before, let I denote the present value of all the income the asset
will generated between 0 and T
▶ Present value of dividends for a stock

▶ Present value of coupons for a bond

▶ Present value of rental for real estate

I claim the no-arbitrage forward price is

F0 = e rT (S0 − I )

32
Adjusting for Income

Consider what happens if F0 > e rT (S0 − I )

Suppose you do the following

▶ Sell the forward contract
▶ Borrow S0 dollars, promising to repay it as:
⋆ I of these dollars to align with the income of the asset
⋆ the remaining S0 − I at time T
▶ Use the borrowed funds to buy the asset today

This is an arbitrage
▶ Net 0 today
▶ Net 0 between time 0 and T (all the income from the asset is used to
pay a portion of the debt)
▶ Earn F0 from delivering asset at T, only need to repay e rT (S0 − I ) on
debt, keep the dierence

33
Adjusting for Income

Now, consider what happens if F0 < e rT (S0 − I )

You can create an arbitrage doing exactly the opposite:

▶ Buy the forward contract
▶ Short-sell the asset at price S0
▶ Save the S0 as
⋆ I of these dollars at maturities that align with the income
⋆ S0 − I at maturity T

This will again be an arbitrage

34
Adjusting for Income

The only price that does not create an arbitrage opportunity is

F0 = e rT (S0 − I )

Intuition: our formula F0 = e rT S0 only applies to assets with no

income, so we cannot apply it directly

Instead, consider a synthetic asset formed by stripping the income

between 0 and T away from the asset
▶ That synthetic asset by construction has no income between now and T
▶ Its price today is S̃0 = S0 − I (value of the asset minus the value of the
income we stripped away)
▶ Applying our formula: F0 = e rT S̃0 = e rT (S0 − I )

35
Example: Stock with Dividend

A stock sells today for $150. You know it will pay a dividend of $10 of
six months, and no more dividends until after one year from now.

Zero rates (p.a., with continuous compounding):

▶ Six-month: 3%
▶ One-year: 4%

The present value of the income (from the dividend) is

1
I = e −0.03× 2 $10 ≈ $9.851

The one-year forward price on the stock is therefore

F0 = e 0.04×1 × ($150 − $9.851) = $145.87

36
Intuition

All else equal, higher income leads to lower forward prices

Think about it: we are comparing two assets with the same price
today, meaning the present value of all their futures payments are
identical
▶ The one with higher income between 0 and T has more front-loaded
income
▶ The one with lower income between 0 and T has more back-loaded
income

The forward contract gets you the asset after that initial income, so it
is a claim on what is left
▶ The one with higher income has less left after T ⇒ lower forward price
▶ The one with lower income has more left after T ⇒ higher forward
price

37
Storage Costs

Some assets are costly to store. Suppose that, in present value terms,
it costs U to store the asset from 0 to T

A cost is the opposite of income, so a storage cost of U is equivalent

to an income of I = −U

Plugging this in, we get

F0 = e rT (S0 + U)

38
Example: Gold

Gold is costly to store

Gold Futures (CME group, all data from August 20, 2024)
▶ Spot price: $80.42/gram
▶ Storage costs: around 4bp/month, ≈ $0.032/gram/month

US Treasury yields (not great, but easy to get)

▶ 1-month: 5.51% (5.497% p.a. with cont. comp.)
▶ 2-month: 5.39% (5.366% p.a. with cont. comp.)
▶ 3-month: 5.31% (5.275% p.a. with cont. comp.)
▶ 4-month: 5.19% (5.146% p.a. with cont. comp.)

PV of storage costs:

1 2
U = e −0.05497× 12 $0.032 + e −0.05366× 12 $0.032
3 4
+ e −0.05275× 12 $0.032 + e −0.05146× 12 $0.032
= $0.127
39
Example: Gold

We have
▶ Spot price: $80.42/gram
▶ PV of storage costs: $0.127/gram
▶ 4-month zero rate: 5.146% p.a. with cont. comp.

Calculate December forward price for gold

4
F0 = e 0.05146× 12 ($80.42 + $0.127) = $81.94

(Actual price for December 2024 futures contract: $81.64/gram)

40
Intuition

All else equal, higher storage costs lead to higher forward prices

The intuition:
▶ If you buy the asset today, you have to pay the storage costs and you

get the asset

▶ If you buy a forward, someone else pays the storage cost, and you get

the asset

The increased forward price is because you have to compensate

someone else for paying the storage costs

41
Yields

Sources of income and costs are often expressed as yields, which is

income or cost relative to the value of the asset
▶ Same idea as interest rate which is actually the interest yield

Just like interest rates, can be expressed annually, with or without

compounding

Example: a stock with dividend yield of 5% per year with semiannual

compounding pays out a dividend equal to 2.5% times its price every 6
months

Can also express it with continuous compounding

42
Forward Price: Income Yield

Suppose that the asset generates income, but this is expressed as a

continuously compounded yield q instead of a present value I

If you are very good with your calculus, you can show the present
value of income is
I = S0 (1 − e −qT )
but this is beyond the scope of this course. Plugging this in

 
F0 = e rT S0 − S0 (1 − e −qT ) = e rT e −qT S0 = e (r −q)T S0

There's a better way to derive exactly the same formula

43
Reinvesting Income Yield

Let's do a thought experiment. Suppose you start with one unit of the
asset. Instead of taking the cash payments it generates, let's reinvest
that into the asset.

At time t, if you earn a fraction a of the value of the asset, you can
buy another a units of that asset
▶ If it's price is St , you get a payment of aSt . That might be risky, so
accounting for the cash is dicult.
▶ However, it also costs St to buy a unit of the asset. So if you get aSt ,
and buy at price St , you can buy a units of the asset.

Now, we are exactly in an analogous state to when we analyzed

interest rates
▶ If we earn r in interest with continuous compounding, after t time the
balance grows from $1 to $e rt
▶ If our asset pays an income yield of q with continuous compounding,
and we reinvest it, after t time the quantity of the asset grows from 1
to e qt
44
Forward Price: Income Yield

One unit of asset grows to e qT , so e −qT grows to 1 unit

Now suppose F0 > e (r −q)T S0 . I claim this generates an arbitrage as

follows:
▶ Sell the forward
▶ Borrow e −qT S0 dollars, and buy e −qT units of the asset
▶ Reinvest any income from the asset into the asset

At time 0, costs nothing

At time T, quantity of asset has grown to 1 unit

▶ Deliver the one unit, get F0
▶ Owe e rT (e −qT S0 ) = e (r −q)T S0 < F0

Risk-free prot of F0 − e (r −q)T S0 at no cost

45
Forward Price: Income Yield

Likewise, if F0 < e (r −q)T S0 we have an arbitrage the other way

So, for an asset with an income yield of q (with continuous

compounding) is
F0 = e (r −q)T S0

46
Forward Price: Cost Yield

A cost might also be expressed as a yield

By the same logic, a cost yield is like a negative income yield.

So, if an asset has a cost yield u, it's like an income yield q = −u ,

from which we get the forward price

F0 = e (r +u)T S0

47
Example: Dividend Yield

Consider a forward on a portfolio of stocks (for example, an ETF)

The portfolio has price $1,000 and a dividend yield of 2% per annum
(with continuous compounding)

The one-year zero rate is 3% per annum (with continuous

compounding)

The price of a one-year forward on the portfolio is

F0 = e (0.03−0.02)×1 $1000 = $1010.05

48
Example: Gold (Again!)

Same example:
▶ Spot price $80.42
▶ Storage costs: 50 basis points per annum (let's assume with continuous

compounding)
▶ Four-month zero rate: 5.146% p.a. with continuous compounding

The price of a three-month forward is

4
F0 = e (0.05146+0.0050)× 12 $80.42 = $81.95

49
Income and Storage Costs

We can combine both parts

If an asset has known income with present value I and storage costs
with present value U between now and T, then its forward price is

F0 = e rT (S0 + U − I )

Can also do it for yields: if it has an income yield of q and a cost yield
of u, then
F0 = e (r +u−q)T S0

50
Cost of Carry

At least for the yield form, we have the general formula

F0 = e (r +u−q)T S0

which can handle income and costs

The term r +u−q has a name

The cost of carry is interest plus storage costs minus any income. In
yield form, it is denoted c

c =r +u−q

Therefore, we have the general formula

F0 = e cT S0

where c is the cost of carry

51
Interest and Cost of Carry

Remember
c =r +u−q

The interest rate r shows up just like storage cost u

This is not a coincidence!

▶ You are compensating the other party for the storage cost: u
▶ Likewise, you are compensating the other party for the opportunity cost

of the interest they could have earned by selling the asset today: r

52
Example: Currency Forwards

Currency forward contract: agreement on an exchange rate

Suppose we express our spot (S ) and forward (F ) exchange rates as

units of domestic currency per unit of foreign currency
▶ Example for HK-based currency forwards: HK dollars per unit of

foreign currency

Let
▶ r : zero-rate in domestic currency
▶ rf : zero-rate in foreign currency (f for foreign)

Then
F0 = e (r −rf )T S0

53
Fast Way

The quick way to derive this is to realize that the cost of carry is

c = r − rf

Why?
▶ r is the zero rate
▶ Foreign currency generates income at a yield of rf
▶ No storage costs

54
Slow Way

Second way to see it is to go directly back to no arbitrage

Investment strategy 1:
▶ Buy a forward contract at price F0 . Nothing happens today, and at
time T you pay F0 units of domestic currency and get 1 unit of foreign.

Investment strategy 2:
−rf T
▶ Borrow e S0 units of domestic currency today, and use this to buy
e −rf T units of foreign, which you save at the foreign rate.
▶ Costs nothing today, and at time T you get 1 unit of the foreign
currency and owe e (r −rf )T S0 of the domestic currency

IfF0 > e (r −rf )T S0 , get an arbitrage by going long strategy 2 and short
1. If F0 < e
(r −rf )T S , get an arbitrage by going long strategy 1 and
0
short 2.

55
Covered Interest Rate Parity

The formula
F0 = e (r −rf )T S0
is also known as covered interest rate parity

Historically, it has held remarkably well for all major currency pairs

However, since the 2008 nancial crisis, there have been persistent
deviations from this formula

56
Violations of CIP

Source: Du, Tepper, and Verdelhan. 2018. Deviations from Covered

Interest Rate Parity. The Journal of Finance, 73(3): 915-957.

57
Violations of CIP

This is not some forward vs. futures deviation. The paper measures
forward prices from forward contracts.

Current explanation: post-crisis regulation has made it dicult for

large institutions to perform the arbitrage trades, and small
institutions nd it hard to enter the market and prot

58
Consumption Asset

So far, we have assumed the underlying asset is an investment asset

Once storage costs and income have been properly accounted for,
investors are indierent between having the asset now or getting it for
sure later

For consumption assets it is dierent. Consumption assets provide

consumption benets, which you only get if you own the asset:
▶ Example: oil, you want to use it to produce
▶ Example: agricultural products, you want to use them to produce food

59
Consumption Asset

Suppose we are considering a forward on a consumption asset, and let

c be its cost of carry

If F0 > e cT S0 , this is still an arbitrage

▶ Sell the forward

▶ Buy the asset with borrowed funds and sit on it (don't consume it)
▶ Deliver the asset, pocket the dierence

However, can we still say F0 < e cT S0 generates an arbitrage? Let's try

it:
▶ Buy the forward
▶ Short the asset? Save the proceeds.

▶ Then use savings to take delivery, return the asset

What goes wrong here? We can't borrow the asset for a short-sale.
It's a consumption asset, so you would be asking someone to delay
consuming.

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Consumption Asset

Therefore, at best we can say

F0 ≤ e cT S0

That is, the price we would have for a forward on an investment asset
e cT S0 is an upper bound for the price on a consumption asset
▶ Any higher price is an arbitrage opportunity, but a lower price reects

the value of being able to consume the asset now

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Convenience Yield

For a forward on a consumption asset

F0 ≤ e cT S0

Suppose you observe the price F0 , and it is lower than e cT S0 . Given

the forward price, we can solve for a value y >0 such that

e yT F0 = e cT S0

We call this value y the convenience yield of the asset. It represents

the value of being able to consume the asset.

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Convenience Yield

Rewrite this as
F0 = e (c−y )T S0

Expanding:
c −y =r +u−q−y

In some sense there are two types of income here:

▶ q: any (monetary) income from the asset, expressed as a yield
▶ y: the non-monetary benets from being able to consume the asset
(instead of having to wait), expressed a yield

This is how we interpret the convenience yield yield: how much benet
being able to consume the asset is providing

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Recap

The price of a forward on an investment asset is

F0 = e rT (S0 + U − I ) F0 = e cT S0 = e (r +u−q)T S0

For a consumption asset, this is an upper bound.

▶ The dierence is the value of the benet of being able to consume the

asset
▶ We can measure this from the price as the convenience yield

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Value of a Forward

The price of a forward is its forward price: the price the buyer is
promising to pay at delivery

This is not the value of the forward contract

In fact, when the contract gets signed, the value of the forward
contract is 0
▶ Why? Any positive value to one party is negative value to the other
▶ If one side gets positive value, the other would never agree

▶ The only way both parties agree is if the value is zero

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Value of an Existing Forward

The same is not true about an existing forward contract

A forward contract signed in the past had zero value then, but after
that things may have moved into one party's favor
▶ If the asset has become more valuable, the long party gets to buy the

asset relatively cheaply, so the long party gets value

▶ If the asset has become less valuable, the short party gets to sell the

asset at a relatively high price, so the short party gets value

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Value of an Existing Forward

Let 0 denote today, and suppose we are considering an existing

forward that will deliver at time T
▶ Time- T zero rate r (p.a., cont. comp.)
▶ K is the forward price on the existing forward contract
▶ F0 is the current forward price (forward price on a new contract)

I claim that the value (to the buyer) of the existing forward is

f = e −rT (F0 − K )

Of course, for the seller, the value of the existing forward is −f

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Value of an Existing Forward

Suppose you are the long party (on an existing forward with forward
price K)

Now, suppose you also sell today's forward at price F0

You now have a portfolio where at the delivery date T:

▶ From the existing forward: you pay K and take delivery of the asset
▶ From the new forward: you deliver the asset and receive F0

Net, at time T, you get F0 − K dollars and simply pass the asset along

This is risk-free, so the present value today of this portfolio is

V = e −rT (F0 − K )

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Value of an Existing Forward

The value of the portfolio is the value of the parts

V = value of existing forward − value of new forward

Now, remember that the new forward is at the current forward price.
Its value is zero. Therefore

V = value of existing forward − value of new forward

|{z} | {z } | {z }
e −rT (F 0 −K ) f 0

We can therefore conclude that the value of an existing forward is

f = e −rT (F0 − K )

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Example

Last week, you went long a forward at price $100. The delivery date is
in two months (from today), and the current forward price is $110.
The two-month zero rate is 2% per year with continuous
compounding.

The value to you is

2
f = e −0.02× 12 ($110 − $100) = $9.97

Quick check: the forward price has gone up. Having a lower price
locked in is good, and indeed we have a positive value.

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Summary

Forwards are contracts to buy an underlying asset at a delivery date at

a (locked in) forward price.

No arbitrage arguments:
▶ Investment asset: F0 = e cT S0
▶ Consumption asset: e yT F0 = e cT S0

Value of an existing forward contract: f = e −rT (F0 − K )

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