Hi all,
I have just encountered a question in blue box in curriculum as follows:
[question removed by moderator]
Suppose that today’s spot rates are:
- 1-year: 1%
- 2-year: 2%
You enter into a 2-year forward contract on Aussie licorice (or whatever); the spot price is S0 = AUD100.00, so the forward price is:
F = S0 × (1 + r)T = AUD100.00 × 1.022 = AUD104.02
Note that the implied forward rate starting 1 year from today is:
1f1 = 1.022 / 1.01 − 1 = 3.0099%
One year passes. You’re still eagerly anticipating the licorice (or whatever). If the current 1-year spot rate were 3.0099%, then you would expect the price of your forward contract to be AUD101.00 (i.e., it should have increased by the original 1-year spot rate). Suppose, instead, that the 1-year spot rate is now 1.5%. Then the price of your forward contract would be:
AUD104.02 / 1.015 = AUD102.50
The price increased above what you thought it would be, because the 1-year spot rate is less than the original 1-year forward rate.
Thanks S2000.
I just wonder why they ask about “price” of forward contract not value and we have to use discount here
You’re welcome.
Because this is the price the long would have to pay (and the short would have to receive) to get out of the forward contract.
It’s one component of the value of the forward contract; the other component is the current spot price on Aussie licorice (or whatever).
We discount it because the agreed price of the forward contract isn’t payable today; it’s payable in one year. The price today is the present value of the price due in one year.
Tricky question, takes a little logic to get this one right. Sometimes on trick questions, I pick the opposite of what my think it is 