Hi,
I am working on some question bank problems and it turns out that forwards are not marked to market. But I thought there was a daily settlement price based on the average of the last period of trading for futures? I thought the same applied to forwards as well?
Isn’t that marking to market?
Also, I don’t seem to understand what the “price” of a futures or forward contract means?
There is a price for the underlying and the contract price for the derivative contract. How is the latter calculated? One equation says, under no arbitrage, it is F0(t)=S0(1+rf)^T.
Another equation gives the “value at time” T? This is S(t)+PV(t)(cost) - PV(t)(benefit) - F0(t)/(1+RF)^(T-t). What’s the rationale for discounting the futures price back? I can’t dissect the equation…
How am I expected to know the differences in these formulas when “price” and “value” are used so interchangeably?
Any clarification is appreciated.
This is my understanding of it:
Futures are traded on an exchange and marked to market, which basically means that on a daily basis, the positions are managed - i.e. the exchange (CBOT) requires that the party which is in the red, add additional funds to the account to maintain position. With futures, there is no credit risk (next to no credit risk) on futures markets.
A frowards contract on the other hand is an agreement to exchange goods and money at a later point in time. Since no exchange is involved, there is credit risk present i.e. from the date of contract inception to maturity date of forwards contract, either party can fail e.g. the cattle may die or the party that is going to be paying for the underlying goods goes out of business. There is no daily addding or subtracting form the accounts of the counterparties.
I think price of a futures or forwards contract is simply the price that will be paid/received at the maturation of the contract for the underlying goods. It’s not like an option whereby you pay say 10c for an option with the share price being $14 dollars. Forwards and futures are basically an agreement at inception and nothing more. Futures are a bit more than that… from inception, they are just an agreement but from the end of day 1 to maturity, there is also a management of the position via adding additional funds.
Price of the underlying is just that… it’s the market price of the item in question… this changes from day to day and can be seen in market prices… i.e. you simply open the chart for the instrument in question e.g. wheat… and there’s your price for the underlying. The price for the futures or forwards contract is simply the agreed upon price between the two counterparties to exchange x number of dollars for xkg of goods and this doesn’t change throughout the duration of the contract forward or future - same thing in either case, it’s not calculated, it’s simply agreed upon by both parties. e.g. you’re a wheat producer and I’m a bread maker and I come to you and say… hey, in 2 months time I want to buy a tonne of wheat from you for $1500/tonne, you can take it or leave it.
Can’t help with the second part of your question regarding pricing. Hopefully someone else will chime in.
The price of a futures or forward contract is the agreed price on the underlying.
Today’s spot price on GOOG is $932.22 per share. The one-year risk-free rate is 3%. The price of a 1-year forward or futures contract on GOOG is $960.19 (= $932.22 × 1.03).
The value of a futures or forward (or swap, or option, or . . . .) is the present value of what you receive less the present value of what you pay. You’re discounting the forward price back to today because that price is one you will pay at expiration, not today.
Remember: cash always grows at its risk-free rate. Always.
You are expected to know the difference between price and value; they’re not remotely interchangeable.