Does the rule that the spot and futures price are the same value at the expiration of a contract apply only to futures, or is it also true for forward contracts? If it is exclusive to futures,could someone please explain why? Is it because futures contracts are marked to market daily?
It is true for both. If it was not true, you could profit from arbitrage transactions the same way you would on a futures contract.
^I don’t think this is correct for forwards. A forward is not a traded product, rather, it’s an agreement entered into by two parties and the contract has a value of zero at inception. That’s why you have counterparty risk in forwards, but not futures. I could very well be incorrect though… L2 Derivatives is a distant memory for me =D
Assuming that you could trade forward contracts and futures contracts up to the instant they expired, the price of the forward or future will converge to the spot price, lest there be an arbitrage opportunity.
It’s true that there is counterparty risk in forwards (but not in futures), but that’s true for both parties; it’s unlikely that there would be a significant increase or decrease in the price out of concern that the counterparty will default. And if there were, it would only be in the direction of compensating the party that is in the money at expiration.
Thank you! How does this relate to the way that we value forwards at the expiration of contracts as V = ST - F(0,T)? Shouldn’t the value then be zero?
No, because the forward price to which we agreed at inception doesn’t change, and the spot price doesn’t care about the price to which we agreed back then.
Suppose that we enter into a 90-day forward contract at a price of $110 when the spot price is $100. As the expiration approaches, we may see the following behavior:
- Time to expiration = 60, spot price = $105, forward price = $113
- Time to expiration = 30, spot price = $95, forward price = $98
- Time to expiration = 15, spot price = $92, forward price = $94
- Time to expiration = 10, spot price = $91, forward price = $93
- Time to expiration = 5, spot price = $95, forward price = $96
- Time to expiration = 0, spot price = $98, forward price = $98
Notice that as we approach expiration, the difference between the spot price and the forward price (i.e., the price if you enter into a forward that day) approaches zero.
At expiration, the spot price is $98, and our forward price is still $110: we gain $12 if we’re the short and lose $12 if we’re the long.
Thank you S2000magician, that was a great explanation.
My pleasure. Glad it helped.
Bumping this a few years later:
S2000 or anyone, the example given above is great. For roll yield in level 3, is this the same thing except we assume the spot is our beginning spot (aka spot doesn’t change)? so F0= 110, S0 = 100, thus (110-100/100) for a short .
If so, why are we assuming that spot doesn’t change? Thanks!