CFA Level II Derivatives

Forward Markets and Contracts

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.
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Contents
1.
2.
3.
4.
5.
6.

Introduction
Structure of Global Forward Markets
Types of Forward Contracts
Pricing and Valuation of Forward Contracts
Credit Risk and Forward Contracts
Role of Forward Markets

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Sections 1, 2 and 3
What is a forward contract

Equity forward contracts

Bond and interest rate forward contracts

Currency forward contracts

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4. Pricing and Valuation of Forward Contracts

1. Generic Pricing and Valuation of a Forward Contract
2. Pricing and Valuation of Equity Forward Contracts
3. Pricing and Valuation of Fixed Income Interest Rate Forward Contracts

4. Pricing and Valuation of Currency Forward Contracts

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4.1 Generic Pricing and Valuation of a Forward Contract

An asset has a current spot price of 100. There are no cash flows associated with this asset. You enter into
a contract to sell this asset at the end of one year. What is the arbitrage-free forward price assuming a
risk-free rate of 10%.

F = S (1 + r)T
Arbitrage transactions if F = 111:

Arbitrage transactions if F = 109:

t=0

Short position on forward contract

Borrow 100 at 10% and buy asset

Long position on forward contract

Short sell asset for 100 and invest at 10%

t=1

Deliver asset and get 111

Payoff loan + interest = 110
Gain = 1

Receive 110
Pay 109 and get asset; cover short position
Gain = 1

Forward price: the price that the two parties agree on at initiation.
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Value of a Forward Contact

An asset has a current spot price of 100. There are no cash flows associated with this asset. The risk free
rate is 10%. You enter into a contract to sell this asset at the end of one year for 110.
What is the value of the forward contract at initiation?
Three months later the spot price is 105. What is the value of the forward contract?

V = S - F / (1 + r)T-t

At initiation value is 0

After three months V = 105 110/1.100.75 = 2.59

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Example 1 Generic Forward Contract

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4.2 Pricing and Valuation of Equity Forward Contracts

Consider a one-year equity forward contract on stock X. This stock is currently priced at $
100.00 and will pay a dividend of $5.00 after six months. Assume the risk free rate is 10%.
What is the forward price?
Forward price = (Stock price Present value of dividends over life of contract) (1 + r)T

Forward price = (Stock price) (1 + r)T Future value of dividends over life of contract

F = 104.76
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Three months later the stock is priced at $102.00. What is the value of the forward contract?

Value after three months: 0.415

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Example 2 Equity Forward Contract

0

50

50

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140

75

140

200

200

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4.3 Pricing and Valuation of Fixed Income and

Interest Rate Contracts

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Example 3 Bond Forward Contract (1/2)

The bond:
150

181

365

547

50

50

50

730
50

The forward contract:

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Example 3 Bond Forward Contract (2/2)

The bond:
515

150

181

365

547

50

50

50

730
50

The forward contract:

0

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365

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Forward Rate Agreements (1/3)

Consider an FRA which expires on Day 270. The underlying is 90 day KIBOR. Currently 270-day KIBOR is
10.00% and 360-day KIBOR is 12.00%. What is the terminology for his FRA? What is the forward rate?
0

270

360

12%
10%

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Forward Rate = 16.74%

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Forward Rate Agreements (2/3)

Move forward to Day 90. Now 180-day KIBOR is 8% and 270-day KIBOR is 9%. What is the value of the
forward contract assuming a notional principal of 100 million?
90

270

360

9%

8%

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Forward Rate Agreements (3/3)

On expiration day, 90-day KIBOR is 8.00%. What is the payoff for the long party?
90

270

360

8%

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Payoff = 2.14 million

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Example 4 Forward Rate Agreements (1/2)

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Example 4 Forward Rate Agreements (2/2)

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FRA Formulas from the Curriculum

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4.4 Pricing and Valuation of Currency Forward Contracts

The spot rate for USD is PKR 100.00. The risk free rate is 10.00% in Pakistan and 1.00% in the U.S. You
enter into a contract to buy $100 million dollars in 1 year. What is the arbitrage-free value for the forward
price?
Forward price = (Spot price discounted by base currency interest rate)
compounded at price currency interest rate

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F = (100 / 1.01) x 1.10 = 108.91

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Three months later the interest rates are the same but the spot price has fallen to PKR 98.00. What is the
value of the forward contract?

Value = Spot price discounted by base currency interest rate

forward price discounted by price currency interest rate

Value = (98/1.010.75) - 108.91/1.100.75 = - 4.13

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Example 5 Currency Forward Contracts

Base currency is the pound

Step 1: Calculate the forward rate

Step 2: Forward is overpriced so sell (go short)

Step 3: Buy in spot market and invest
Step 4: Deliver on forward contract

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Currency Forwards - Formulas from the Curriculum

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5. Credit Risk and Forward Contracts

Credit risk in a forward contract arises when the counterparty that owes the greater amount is
unable to pay at expiration or declares bankruptcy prior to expiration.
The value of a forward contract is a measure of credit risk.

Only one party, the one owing the lesser amount, faces credit risk at any given time. Because the
market value can change from positive to negative, however, the other party has the potential for
facing credit risk at a later date.
Counterparties occasionally mark forward contracts to market, with one party paying the other
the current market value; they then re-price the contract to the current market price or rate.

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6. The Role of Forward Markets

Forward markets play an important role in society, providing a means by which a select clientele of
parties can engage in customized, private, unregulated transactions that commit them to buying
or selling an asset at a later date at an agreed-upon price without paying any cash at the start.
Forward contracts also are a simplified version of both futures and swaps and, therefore, form a
basis for understanding these other derivatives.

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Summary
Price and value of a forward contract
Forward contracts on equity and bonds
Forward rate agreements
Currency forward contracts
Credit risk

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Conclusion
Read summary
Review learning objectives
Examples
Practice problems
Practice from other sources

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