A. How does forward contract valuation differ from future contract valuation?

Valuation on a forward contract is the cash settlement that would be required if there was a default on the contract. The valuation of the forward contract is done on the expiration of the contract. Value at contract maturity (T) = Spot price at maturity T Forward price VT(0,T) = ST F(0,T) Or Forward contract value = quantity X (spot price PV of forward price)

The valuation of the future contract is done on daily basis. Vt (T) = Value of future contract at the end-of-day less value of futures contract at end-of day. Vt (T) = ft (T) ft 1(T) Where [ft (T) ft 1(T)] = daily margin variation Or Future contract value = Number of contract X size of contract X daily margin variation.

If spot price > forward price = negative (short position) & positive (Long position). If spot price < forward price = positive (short position) & negative (long position)

B. When valuing forward contracts, explain how market position determines positive and negative value? Spot price refers to establishing today price for a transaction today. In short for calculation of spot price derivatives is not involved. Forward pricing refers to determine a forward price for a future transaction date it will be either at a premium or discount to the spot price. Market position: If one party long and on party short signs a forward contract the immediate market position is neutral for both parties.

Market position Long Short

Offsetting position Short Long

Strategy Hedge Hedge

Risk management Netural Netural

It calculates the credit exposure or the risk of the forward contract. One party will have positive valuation and other negative valuation. When market position is initially long: - Becomes a seller.

- Owns an asset - Risk is on the down side. Market position when default in a forward contract: - Under contract default assume a short position - Risk is on the upside (negative value) - Gain through default risk on the downside (positive value) When market position is initially short: - Becomes a buyer. - Need to buy, borrow, an asset - Risk is on the up side. Market position when default in a forward contract: - Under contract default assume a long position - Risk is on the downside (negative value) - Gain through default risk on the upside (positive value) The value of a forward contract = default value = difference contract size X market difference.

C. When valuing futures contract, explain how market position determine positive and negative value?

In calculation of futures contract when the Initial position is Long then the initial risk position is on the down side and after getting into a contract the risk becomes neutral. The value after getting into a contact would be negative if the price at the termination of the contract is greater than the future contract price. If there is a default than the risk would be at the downside and the valuation of the contact would be positive. It would be the opposite when the Initial position is Short then the initial risk position is on the up side as we are the buyer and after getting into a future contract the risk becomes neutral. The value after getting into a contact would be positive if the price at the termination of the contract is greater than the future contract price. If there is a default than the risk would be at the upside and the valuation of the contact would be negative.

D. Using examples to illustrate, what other factor (other them market position) are important when calculating forward and future contract valuation. When calculating forward and future contract valuation many factors are taken into consideration: Such as cash inflow, cash outflow, the time value of money, interest rate, storage cost, carrying cost, divided. Illustrate 1. Taking divided into consideration for forwards. An asset manager anticipates the receipt of funds in 200 days, which he will use to purchase company shares. The shares are currently selling for $62.50 and are expected to pay $0.75 divided in 50 days and other $0.75 divided in 140 days. The interest rate is 4.2% p.a. The manger decided to commit to a future purchase of the shares with a forward contract. What is the value of the equity forward contract, 75 days after entering the contract if the share pice is then $55.75

 The price of the equity forward contract would be: F(0,T) = [S0 PV (D,0,t)] (1+r)T Where PV (D,0,T) = Di (1+r)ti PV (D,0,T) = $0.75/(1+0.042)50/365 $0.75/(1+0.042)140/365 = $1.48 F (0,T) = F(0,200/365) = ($62.50-$1.48) (1+0.042)200/365 =$62.41

The price of the equity forward contract would be: Vt (0,T) = St PV (D,t,T) F(0,T)/(1+r)(T-t) Where = $0.75/(1+0.042)65/365 = $0.74 Vt(0,T) = V75/365(0,200/365) = ($55.75- $0.75) - $62.41/(1+0.042)125/365 = -$6.53.

Illustrate 2. Pricing of forward contract with fixed interest bond: Consider a bond with semi-annual (coupon) interest payments. The bond has a current maturity of 583 days. The next interest payment occurs in 37 days, followed by payments in 219, 401 and 583 days. Suppose the bond price which included accured interest $984.45 for a $1000 par 4% interest bond. Risk free rate is 5.75%p.a. Assume that the forward contract expires in 310 days. What is the price of the forward contract on the bond? The price of the forward contract on the bond be F(0,T) = [Bc0 (T + Y) PV (CI,0T)] (1+r)T = FV (spot bond price PV of coupon) Where

PV (CI, 0T) = 20/(1.0575)37/365 + 20/ (1.0575)219/365 = 39.23 F(0,T) = (984.45 -39.23) (1+0.0575)310/365 = 991.18 Now assume it is 15 days later and the new bond price is $973.14. Risk free interest rate is now 6.75% p.a What is the price of the forward contract on the bond? The value of the forward contract would be V(0,T) = [Bc0 (T + Y) PV (CI,0T)] - F(0,T)/(1+r)(T-t) PV (CI,0T) = 20/(1.0675)22/365 + 20/ (1.0675)204/365 = 39.20 Where V(0,T) = 973.14 -39.20 991.18/ (1.0675)295/365 = -6.28 Illustrate 3. A cash cost incurred from holding the asset increase the forward future price. (Carrying cost, storage cost) A cash benefit incurred from holding the asset decrease the future price. (Dividends, bonds interest) Taking cost of money when calculating profit on future hedge = FT (T) F0 (T) Cost of money = Final futures price Initial futures price - cost of money You hold an asset valued at $100. You establish a short futures hedge at $108 At maturity 12 months later you deliver against the future contract there by eliminating basis risk

The cost money is 5.00%p.a What is the futures hedge profit? Future hedge profit per contract = Initial basis cost of money = $108 - $100 - $5 (5%*$100) = $3/contract Illustrate 4. Assuming no basic or basic movement with storage cost. Spot asset price = $50 Interest rate = 6.25% Future value of the storage cost = $1.35 What should the future price be at maturity in 15 month? F0(T) = S0 (1+r)T + FV(SC,0T) F0(1.25) = 50 (1+0.0625)1.25 + 1.35 = $55.29