# Forward Contract question

Hi All - got a question that is freaking me out a bit, it would be awesome if anyone could help!

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A security is currently worth \$225. An investor plans to purchase this asset in one year and is concerned the price will rise by then. To hedge this risk, the investor enters into a forward contract to buy the asset in one year. Assume that the risk free rate is 4.75%.

(here I calculated the forward price as \$235.69)

Suppose that at expiration, the price of the asset is \$190. Calculate the value of the forward contract at expiration. Also indicate the overall gain or loss to the investor on the whole transaction.

S[T] = \$190 F(0,T) = \$235.69 VT = \$190 - \$235.69 = -\$45.69 Loss to long position = -\$45.69** Gain on asset = \$35 (based on \$225 - \$190) Net loss = -\$10.69**

The bit in bold is very confusing. If I am contracted to pay \$235.69 for something worth \$190, why do I then need to add back the loss on the asset? Why isn’t the gain/loss on the whole transaction the same as the forward contract value, if the investor doesn’t already own the asset?

Thanks!

See if this makes sense to you. I had answered this same question a while back…

Choices for investor:

He entered into a forward contract -> with a price of 235.69.

Buy asset 1 year later at 190… (expiration price).

In terms of buying asset now vs. later - that he was able to buy it at expiration for 190 is a gain for him vs. buying it today. Since the price of asset dropped in the period.

It is a loss in terms of what he had to pay. He had to pay 235.69 -> due to the forward, but market price was only 190 -> so a loss of 45.69.

What’s the use of the 10.69 figure? Is the long going to default and then buy at the price at expiration?

I was covering this on Monday with a Level II candidate I tutor.

The question is poorly worded. They intend for you to understand that you would have either bought the stock in the spot market at \$225, or else bought it in the forward market at \$235.69. So the effect of the forward transaction is a loss of \$10.69, irrespective of the price of the stock at expiration of the forward.

The questions on the real exam won’t be ambiguous.

Thanks all - I was hoping there would be something wrong with the question!