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McGraw-Hill/Irwin
Rangarajan K. Sundaram
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Rangarajan K. Sundaram
Objectives
This segment Introduces the following major classes of derivative securities Forwards Futures Options Discusses their broad characteristics and points of distinction. Discusses their uses at a general level. The objective is introductory: to lay the foundations for the detailed analysis of derivative securities.
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Derivatives
A derivative security is a financial security whose value depends on (or derives from) other, more fundamental, underlying financial variables such as the price of a stock, an interest rate, an index level, a commodity price or an exchange rate. In this module we focus on the following classes of derivative securities: Futures & forwards. Options
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Basic Distinctions - I
Forward contracts are those where two parties agree to a specified trade at a specified point in the future. Defining characteristic: Both parties commit to taking part in the trade or exchange specified in the contract. Futures are variants on this theme: Futures contracts are forward contracts where buyers and sellers trade through an exchange rather than bilaterally.
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Basic Distinctions II
Options: Characterized by optionality concerning the specified trade. One party, the option holder, retains the right to enforce or opt out of the trade. The other party, the option writer, has a contingent obligation to take part in the trade. Call option: Option holder has the right, but not the obligation, to buy the underlying asset at the price specified in the contract. Option writer has a contingent obligation to participate in the specified trade as the seller. Put option: Holder has the right, but not the obligation, to sell the underlying asset at the price specified in the contract. Option writer has a contingent obligation to participate in the specified trade as the buyer.
Derivatives: Principles & Practice
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Risk-Management Roles - I
These classes of derivatives serve important, but different, purposes. Futures and forwards enable investors to lock in cash flows from future transactions. Thus, they are instruments for hedging risk. "Hedging" is the offsetting of an existing cash-flow risk. Example A company that needs to procure crude oil in one month can use a one-month crude oil futures contract to lock in a price for the oil.
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Risk-Management Roles - II
Options provide one-sided protection. The option confers a right without an obligation. As a consequence: Call Protection against price increase. Put Protection against price decrease. Example Suppose a company needs to procure oil in one month. If the company buys a call option, it has the right to buy oil at the "strike price" specified in the contract. If the price of oil in one month is lower than the strike price, the company can opt out of the contract. Thus, the company can take advantage of price decreases but is protected against price increases. In short, options provide financial insurance.
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The rest of the material defines these classes of instruments more formally. Order of coverage: Forwards Futures Options
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Forward Contracts
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Forward Contracts
The building block of most other derivatives, forwards are thousands of years old. A forward contract is a bilateral agreement between two counterparties a buyer (or "long position"), and a seller (or "short position") to trade in a specified quantity of a specified good (the "underlying") at a specified price (the "delivery price") on a specified date (the "maturity date") in the future. The delivery price is related to, but not quite the same thing as, the "forward price." The forward price will be defined shortly.
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Forwards: Characteristics
Important characteristics of a forward contract: Bilateral contract Negotiated directly by seller and buyer. Customizable Terms of the contract can be "tailored." Credit Risk There is possible default risk for both parties. Futures & forwards differ on precisely these characteristics as we see shortly.
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BUT...
An obvious but important point: The elimination of cash flow uncertainty using a forward does not come "for free." A forward contract involves a trade at a price that may be "off-market," i.e., that may differ from the actual spot price of the underlying at maturity. Depending on whether the agreed-upon delivery price is higher or lower than the spot price at maturity, one party will gain and the other party lose from the transaction.
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An Example
A US-based exporter anticipates 200 million of exports and hedges against fluctuations in the exchange rate by selling 200 million forward at $1.30/. Benefit? Cash-flow certainty: receipts in $ are known. Cost? Exchange-rate fluctuations may lead to ex-post regret. Exchange rate at maturity is $1.40/. Exporter loses $0.10/ for a total loss of $20 million on the hedging strategy. Exchange rate at maturity is $1.20/. Exporter gains $0.10/ for a total gain of $20 million on the hedging strategy.
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ST : Spot price at maturity of forward contract. F : Delivery price locked-in on forward contract.
Derivatives: Principles & Practice
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We have seen what is meant by the delivery price in a forward contract. What is meant by a forward price? The forward price is a breakeven delivery price: it is the delivery price that would make the contract have zero value to both parties at inception. Intuitively, it is the price at which neither party would be willing to pay anything to enter into the contract.
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At inception of the contract, the delivery price is set equal to the forward price. Thus, at inception, the forward price and delivery price are the same. As time moves on, the forward price will typically change, but the delivery price in a contract, of course, remains fixed. So while a forward contract necessarily has zero value at inception, the value of the contract could become positive or negative as time moves on. That is, the locked-in delivery price may look favorable or unfavorable compared to the forward price on a fresh contract with the same maturity.
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Futures Contracts
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Futures Contracts
A futures contract is like a forward contract except that it is traded on an organized exchange. This results in some important differences. In a futures contract: Buyers and sellers deal through the exchange, not directly. Contract terms are standardized. Default risk is borne by the exchange, and not by the individual parties to the contract. "Margin accounts" (a.k.a "performance bonds") are used to manage default risk. Either party can reverse its position at any time by closing out its contract.
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Options
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Basic Definitions
An option is a financial security that gives the holder the right to buy or sell a specified quantity of a specified asset at a specified price on or before a specified date. Buy = Call option. Sell = Put option On/before: American. Only on: European Specified price = Strike or exercise price Specified date = Maturity or expiration date Specified asset = "underlying" Buyer = holder = long position Seller = writer = short position
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Exchange-traded options: Stocks (American). Futures (American). Indices (European & American) Currencies (European and American) OTC options: Vanilla (standard calls/puts as defined above). Exotic (everything elsee.g., Asians, barriers). Others (e.g., embedded options such as convertible bonds or callable bonds).
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As we have noted above, option provides financial insurance. The holder of the option has the right, but not the obligation, to take part in the trade specified in the option. This right will be exercised only if it is in the holder's interest to do so. This means the holder can profit, but cannot lose, from the exercise decision.
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K=
If the price falls below $22.50, the put can be exercised and the stock sold for $22.50. If the price increases beyond $22.50, the put can be allowed to lapse and the stock sold at the higher price. In general, puts provide potential sellers of the underlying with insurance against declines in the underlying's price. The higher the strike (or the longer the maturity), the greater the amount of insurance provided by the put.
Derivatives: Principles & Practice
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The writer of the option provides this insurance to the holder: The writer is obligated to take part in the trade if the holder should so decide. In exchange, writer receives a fee called the option price or the option premium. Chapters 9-16 are concerned with various aspects of the option premium including the principal determinants of this price and models for identifying fair value of an option. Chapter 17 discusses how to measure the risk in an option or a portfolio of options. Chapters 18 and 19 extend the pricing analysis to "exotic" options. Chapter 21 studies hybrid securities such as convertible bonds that have embedded optionalities.
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Outline
Introduction Standardized Contract Terms Default Risk and Margin Accounts Futures Pricing
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Introduction
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Objectives
Futures contracts are the exchange-traded counterparts of forward contracts. Key features distinguishing futures contracts from forward contracts: The standardization of futures contracts. The ability to unilaterally reverse positions. The use of margin accounts or \performance bonds" to control default by investors in the market.
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The Origins
As economic mechanisms, forward markets are very old. Futures Industry Association traces the origin of forward trading to India around 2,000 BC. Substantial evidence of forward markets in Greco-Roman and medieval Europe. World's first futures market was quite possibly the Dojima Rice Market (Osaka, 1730).
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Modern futures markets are most associated with 19th century America, particularly the grain markets of Chicago. The Chicago Board of Trade (CBoT) was established in 1848. Swiftly followed by a number of other exchanges (New York, Milwaukee, St. Louis, Kansas City, ... ). Over a thousand commodity exchanges sprang up in the US by the end of the 19th century.
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Standardization
Contract terms must be standardized, since buyer and seller do not interact directly. Standardization is perhaps the most important task performed by the exchange. Essential in promoting liquidity and improving quality of hedge. Apart from contract maturity dates, standardization involves three components: 1. Quantity (size of contract). 2. Quality (standard deliverable grade). 3. Delivery options (other deliverable grades + price adjustment mechanism).
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Exchange: Chicago Board of Trade (CBoT). Contract months: March, May, July, September, December. Size: 5,000 bushels. Quality: No. 2 Yellow Corn. Delivery options: No. 1 Yellow and No. 3 Yellow may also be delivered. If No. 1 Yellow is delivered, the short position receives 1.5 cents per bushel more than the contract price. If No. 3 Yellow is delivered, the short position receives 1.5 cents per bushel less than the contract price.
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Exchange: Chicago Mercantile Exchange (CME) Contract months: March, June, September, December. Size: 12,500,000 Yen. Quality: Not relevant. Delivery options: None.
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Why provide delivery options in futures contracts? It makes corners and squeezes more difficult. Enhance market liquidity. However, there is an important cost: the quality of the hedge is degraded. The delivered grade is not the standard grade, but the cheapest-to-deliver grade.
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Margin Accounts
Since buyers and sellers do not interact directly, there is an incentive for either party to default if prices move adversely. To inhibit default, futures exchanges use margin accounts. This is effectively the posting of collateral against default. The level at which margins are set is crucial for liquidity. Too high levels eliminate default, but inhibit market participation. Too low levels increase default risk. In practice, margin levels are not set very high.
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Initial margin. Amount initially deposited by investor into margin account. Marking-to-market. Daily adjustment of margin account balances to reflect gains/losses from futures price movements over the day. Maintenence margin. Floor level of margin account. If balance falls below this, customer receives margin call. If the margin call is not met, account is closed out immediately.
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Margining: An Example
Investor takes long position in 10 wheat futures contracts at a futures price of $3.60 per bushel. Size of one futures contract: 5,000 bushels. Thus, futures price: $18,000 per contract. Suppose that Initial margin = $878 per contract. Maintenence margin = $650 per contract.
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Example: Marking-to-Market
Settlement price on day 1: $3.58 per bushel = $17,900 per contract. "Loss" from holding long contract at $3.60: $100/contract. Total "loss" = $1,000: debited from the margin account. Margin account balance: $7,780. Effectively: Original contract at $3.60/bushel has been replaced with new contract at $3.58/bushel. Difference is debited from the margin account. Of course, margin account of corresponding short position would increase by $1,000.
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Example: Marking-to-Market
Settlement price on day 2: $3.54 per bushel = $17,700 per contract. "Loss" per contract: $(17, 900 17, 700) = $200 per contract. Total loss = $2,000; debited from the margin account. New margin account balance: $5,780. Since balance is less than maintenance margin, margin call results. If account is topped up (to initial margin levels), situation continues. If not, investor's position is closed out.
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Margining: Summary
To reiterate: marking-to-market essentially involves: Rewriting the customer's futures contract at the current settlement price, and settling immediately the gains or losses to the customer from the rewiting. Basic idea: If an investor is not able to meet "small" losses (from price movements over a day), it is unlikely he will be able to meet larger losses that might result. Historically, margining has worked very well in inhibiting default. Exchanges also retain right to change margin at any time. Used to defuse potentially market-threatening situations (e.g., 1980silver crisis).
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Futures Pricing
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Analytical valuation of futures contracts complicated by two considerations: 1. Delivery options provided to the short position. 2. Margining which creates uncertain interim cash flows. These features will have an impact on futures prices compared to another wise identical forward contract. The question is: how much of an effect? Is it quantitatively significant? For most futures contracts (especially short-dated ones), it turns out the effect is minimal: such contracts can be priced as if they are forward contracts.
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Chapter 3
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Outline
Introduction Pricing Forwards by Replication Numerical Examples Currency Forwards Stock Index Forwards Valuing Forwards
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Introduction
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Objectives
This chapter introduces students to the pricing of derivatives using noarbitrage considerations. Key points: 1. The cost-of-carry method of pricing forward contracts. 2. The role of interest rates and holding costs/benefits in this process. 3. The valuation of existing forward contracts.
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Forward price: The delivery price that makes the forward contract have "zero value" to both parties. How do we identify this zero-value price? Combine The Key Assumption: No arbitrage with The Guiding Principle: Replication.
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Forward contracts are relatively easy to price by replication. Consider an investor who wants to take a long forward position. Notation: S : current spot price of asset. T : maturity of forward contract (in years). F : forward price for this contract (to be determined). We will let 0 denote the current date, so T is also the maturity date of forward contract.
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Replicating Forwards
At maturity of the contract, the investor pays $F and receives one unit of the underlying. To replicate this final holding: Buy one unit of the asset today and hold it to date T. Both strategies result in the same final holding of one unit of the underlying at T. So, viewed from today, they must have the same cost. What are these costs?
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The forward strategy involves a single cash outflow of the delivery price F at time T So, cost of forward strategy: PV (F ).
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To replicate, we must Buy the asset today at its current spot price S. "Carry" the asset to date T. This involves:
Possible holding/carrying costs (storage, insurance). Possible holding benefits (dividends, convenience yield).
Let
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Solving this condition for F, we obtain the unique forward price consistent with no-arbitrage.
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If PV (F ) > S + M, the forward is overvalued relative to spot. Arbitrage profits may be made by selling forward and buying spot. "Cash and carry" arbitrage. Forward contract has positive value to the short, negative value to the long. If PV (F ) < S + M, the forward is undervalued relative to spot. Arbitrage profits can be made by buying forward and selling spot. "Reverse Cash and carry" arbitrage. The contract has positive value to the long and negative value to the short.
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The forward price is completely determined by three inputs: Current price S of the spot asset. The cost M of "carrying" the spot asset to date T. The level of interest rates which determine present values. This is commonly referred to as the cost-of-carry method of pricing forwards. Two comments: Forward and spot prices are tied together by arbitrage: they must move in "lockstep." To what extent then do (or can) forward prices embody expectations of future spot prices?
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Fundamental pricing equation: PV (F) = S + M. Let r be the continuously-compounded interest rate for horizon T. So PV (F ) = e rT F. Therefore, e rT F = S + M, so
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Numerical Examples
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Example 1
Consider a forward contract on gold. Suppose that: Spot price: S = $1, 140/ oz. Contract length: T = 1 month = 1/12 years. Interest rate: r = 2.80% (continuously compounded). No holding costs or benefits. Then, from the forward pricing formula, we have
Any other forward price leads to arbitrage. If F > 1, 142.66, sell forward and buy spot. If F < 1, 142.66, buy forward and sell spot.
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Suppose that F = 1, 125, i.e., it is underpriced by $17.66. Arbitrage strategy: 1. Enter into long forward contract. 2. Short 1 oz. of gold. 3. Invest $1,140 for one month at 2.80%.
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Holding costs are often non-zero. With equities or bonds, there are often holding benefits such as dividends or coupons. With commodities, there are often holding costs such as storage and insurance. Such interim cash flows affect the total cost of the replication strategy and should be taken into account in pricing. Our second example deals with such a situation.
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Example 2
Consider a forward contract on a bond. Suppose that: Spot price of bond: S = 95. Contract length: T = 6 months. Interest rate: r = 10% (continuously compounded) for all maturities. Coupon of $5 will be paid to bond holders in 3 months. What is the forward price of the bond?
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The coupon is a holding benefit. So M is minus the present value of $5 receivable in 3 months:
so
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For example, suppose F = 98. Then, the forward is overvalued relative to spot, so we want to sell forward, buy spot, and borrow. Buying and holding the spot asset leads to a cash outflow of 95 today, but we receive a coupon of 5 in 3 months. There are may ways to structure the arbitrage strategy. Here is one. We split the initial borrowing of 95 into two parts, with one part repaid in 3 months with the $5 coupon, and the balance repaid in six months with the delivery price received on the forward contract.
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So the full arbitrage strategy is: Enter into short forward with the delivery price of 98. Buy the bond for 95 and hold for 6 months. Finance spot purchase by borrowing 4.877 for 3 months at 10% borrowing 90.123 for 6 months at 10%. In 3 months: receive coupon $5 repay the 3-month borrowing. In 6 months: deliver bond on forward contract and receive $98 repay 6-month borrowing.
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Currency Forwards
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Forwards on currencies need a slightly modified argument. For example, suppose you want to be long 1 on date T. Two strategies: Forward contract: Pay $F at time T, receive 1. Replicating strategy: Buy x today and invest it to T, where x = PV (1). PV(1) is the amount that when invested at the sterling interest rate will grow to 1 by time T. The "" inside the PV expression is to emphasize that present values are being taken with respect to the interest rate.
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Cost of the forward strategy in USD: PV ($ F ) = F x PV ($1). Cost of the spot (or replicating) strategy in USD: S x PV (1) As usual, S denotes the spot price of the underlying in USD. Here, the underlying is GBP, so S is the spot exchange rate ( $ per ).
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S x PV (1) = F x PV ($1).
Solving we obtain the fundamental forward pricing expression for currencies:
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Let r represent the T-year USD interest rate and d the T-year GBP interest rate, both expressed in continuously-compounded terms. Then, PV ($ 1) = erT and PV (1) = edT . Using these in the general currency forward pricing expression and simplifying, we obtain
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We can also price forwards on stock indices using this approach. A stock index is essentially a basket of a number of stocks. If the stocks pay dividends at different times, we can approximate the dividend payments well by assuming they are continuously paid. Dividend yield on the index plays the role of the variable d in the formula. Literally speaking, the idea of continuous dividends is an unrealistic one, but, in general, the approximation works very well. Computationally, much simpler than calculating cash value of dividend payments expected over contract life and using the known-cash-payouts formula.
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Data: Current level of S&P index: 1,343 One-month interest rate (continuously-compounded): 2.80% Dividend yield on the S&P 500: 1.30% What is the price of a one-month (= 1/12 year) futures contract? In our notation: S = 1343, r = 2.80%, d = 1.30%, and T = 1/12. So the theoretical futures price is
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Valuing Forwards
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Consider a forward contract with delivery price K that was entered into earlier and now has T years left to maturity. What is the current value of such a contract? We answer this question for the long position. The value of the contract to the short position is just the negative of the value to the long position. So suppose we are long the existing contract. Suppose also that the current forward price for the same contract (same underlying, same maturity date) is F.
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Consider offsetting the existing long forward position with a short forward position in a new forward contract. Original portfolio: Long forward contract with delivery price K and maturity T. New portfolio: Long forward contract with delivery price K and maturity T. Short forward contract with delivery price F and maturity T. Value of original portfolio = Value of new portfolio (why?).
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Valuation by Offset
What happens to the new portfolio at maturity? Physical obligations in the underlying offset. Net cash flow: F K. So new portfolio - certainty cash flow of F K at time T. This means: Value of New Portfolio = PV (F K ). Therefore: Value of Long Forward = PV (F K ). and Value of Corresponding Short Forward = PV (K F ).
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A forward contract is a commitment by buyer and seller to take part in a fully specified future trade. The commitment to the trade makes forward payoffs linear. The forward price is that delivery price that would make the contract have zero value to both parties at inception. The forward price can be determined by replication, and depends on the cost of buying and "carrying" spot. The value of a forward contract is the present value of the difference between the locked-in delivery price on a contract and the current forward price for that maturity.
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