I find it easy to figure out the price/value of the forward contracts. However, what i’m having a problem with is figuring out the net gain/loss at expiration for an investor. I know whether it’s a gain/loss based on if the investor is short/long but what i’m having a problem with is the consolidation of position loss/gain on forward with the gain/loss on the asset.
For example,
asset at time = 0 : $200
you want to buy it in a yr so you enter into forward contract. With r= 0.05, the forward contract is priced at $210
if at t=expiration, the asset is worth $150, the value of forward contract = $150-210= therefore $60 loss on forward
Why do we also calculate $200-150 as gain on asset and subtract that from the loss on forward?
We don’t own the asset and we’re not buying an asset at $210 that is only worth $150!
Because the asset is now cheaper. So instead of expending 200, you’d now be paying 150 to buy the asset. Longing a forward means you must take delivery of the asset. Once that asset is at your doorstep, it’s worth 150, not 200, hence, the gain.
Further to the question… forward contract is booked to avoid loss due to increase in prices after a time period. On expiry investor will receive asset at the froward rate and as he will have to get rid of the asset, will sell in the market at the spot rate.
In the above example forward rate = 210 and spot rate = 150
when he receives an asset worth 210 and sells in the market for 150, he looses 60
What is mean to say is just because the asset price has come down the investor is not going to pay the present market rate but he will still have to pay the forward rate for taking the delivery of the asset, so where is the question of gain…
Kindly elaborate on your answer…it will be very helpful…
As Aether mentioned in some other thread, the overall loss/gain on the trasaction is based on the concept of opportunity cost.
Additionally it also depends on the terms of expiration of the contract; Is it physical delivery or cash settlement.
IN terms of physical delivery the calculation would be ,
Take delivery of asset for agreed price of $210
And now you actually hold an asset which is worth $150. So you made a loss on $60.
IN Cash Settlement,
Pay the loss on the contract i.e. $ 60
But you don’t have to buy the asset at $210 and in fact you can buy the asset at $150. This is cheaper than it was originally available at 200. So your gain from the opportunity was 200-150 = 50