What Is the Fair Value of a Forward Contract Formula?
When it comes to hedging or speculating on future prices of assets, forward contracts are a common financial instrument used. They allow two parties to agree on a price for the exchange of an asset at a future date. However, determining the fair value of a forward contract can be challenging.
The fair value of a forward contract is the theoretical price at which the contract should be trading in the market at any given time. It is based on the current spot price of the underlying asset, time to expiration, and the cost of carry, which is the cost of holding the asset until the contract’s expiration.
To calculate the fair value of a forward contract formula, the following steps are usually taken:
1. Determine the current spot price
The current spot price is the price of the underlying asset at the present time. It serves as the starting point for calculating the fair value of the forward contract.
2. Determine the cost of carry
The cost of carry is the cost of holding the asset until the expiration of the contract. In other words, it is the cost of financing and storing the asset until the contract’s expiration date. This cost includes interest rates, storage and insurance fees, and any dividends or income the asset generates.
3. Calculate the forward price
A forward price is the price at which the two parties agree to trade the asset at the expiration date of the contract. It is calculated by adding the cost of carry to the current spot price.
4. Calculate the fair value of the forward contract
The fair value of the forward contract is the difference between the forward price and the current spot price. It represents the theoretical value of the contract and reflects the market`s expectation of the future price of the asset.
The fair value of a forward contract formula is important because it helps investors and traders determine whether a contract is overvalued or undervalued. If the market price of the forward contract is higher than its fair value, it may be considered overvalued, and vice versa.
In conclusion, determining the fair value of a forward contract formula involves calculating the current spot price, cost of carry, and forward price. This calculation can help investors and traders make informed decisions about buying or selling forward contracts.