I really don’t understand the rationale for the answer below.
thank you so much for your time.
The contract price of a forward contract is:
A) always the present value of the expected future spot price. B) the price that makes the contract a zero-value investment at initiation. C) determined at the settlement date.
Your answer: A was incorrect. The correct answer was B) the price that makes the contract a zero-value investment at initiation.
The contract price can be an interest rate, discount, yield to maturity, or exchange rate. The forward price is the future value of the spot price adjusted for any periodic payments expected from the asset. An example of when the forward price may be less than the spot price is in the case of an equity index contract where the dividend yield is greater than the risk-free rate.
B is the definition of a forward price. Let’s say you enter into a contract to buy 1 barrel of crude oil 1 year from now. There can only be one price at which both the buyer and seller are indifferent. You can do some mental exercises to convince yourself why this must be true.
Although the forward and futures prices are theoretically the same, this relationship does not always hold true. We can see a divergence resulting from the preferences of investors of having to mark-to-market. Keep in mind these investor preferences are tied to the correlation between the value of the underlying asset and interest rates. So _ WHEN _ rates and asset prices are postively correlated, long holders will prefer benefit from the daily pricing and settlement of futures, and will prefer futures to forwards. _ WHEN _ rates and asset prices are negatively correlated, parties favor forwards as opposed to futures.
The key word ALWAYS is what allows us to eliminate Answer (A).