In valuing a particular forward contract at any point in time , we compare the then current spot price of the underlying asset to the present value of the initially agreed upon forward price to determine how much value a position holds to the long or short…
but in caluing a currency forward contract prior to expiration, the formula is
Vt(0,t) =St/(1+rf)^(T-t) - F/(1+rd)^(T-t)
St and F are specified as DC/FC… here why is the spot price discounted… Thanks in advance
Also While calculating value of the forward contract on the equity index (continuous dividends), why is the spot price at time t discounted at the dividend yield? Thanks in advance for your help.
Spot price is discounted here beacause in currency forward contracts and fair price calculation there are two currencies involved here . One is domestic currency and other is foreign currency .And so there are two interest rates involved . one is domestic and other is foreign .
Take a look at the article I wrote on this; it may be of some help: http://financialexamhelp123.com/valuing-a-currency-forward-whence-came-that-formula/.
The short answer is that currencies are assumed to grow at the risk-free rate (i.e., the particular risk-free rate for that currency). Thus, if you value a currency forward before expiration, the amount of currency delivered will not be the contracted amount, but the present value of the contracted amount. Currencies are wonky commodities in that respect. (Note: I wrote an article on that as well: http://financialexamhelp123.com/cash-currency-the-wonky-commodity/.)
Two currencies and two interest rates involved in a currency forward? Who’d have thunk? Thanks
Welcome to the club. Did you pick up your lanyard at the door?