if trader expects that the future spot rate will be lower than what is predicted by prevailing forward rate, forward contract value is expected to increase
can someone enlighten me how to comprehend this?
it is a bond… what happens to a bond price when rates fall?
i understand the price of bond goes up, but maybe i am not understanding the value of forward contract well, isnt that the profit you making out of the forward, or the forward contract price mean the exercise price?
I believe this has something to do with the difference between what the investor has predicted and what the actual market condition is.
Basically, what this means is that the market discounts the value of the contract by a higher forward rate.
Investor belives that the future spot rate will be less than the forward rate that the market has determined today.
Assuming, the investor is correct, he has basically found out an undervalued contract.
Therefore, he could buy the contract now to realise the profits at the specific point of time when the spot rate applies.
PS:- GO THROUGH THE DEFINITION OF FUTURE SPOT RATE AND THE FORWARD RATE. UNDERSTAND THE IMPLICATION OF NO-ARBRITRAGE CONDITION. THEN THIS CONCEPT SHOULD BE FINE.
Value of forward = (St-PVC)-[FP/(1+r)^T-t]
That is, spot price (net of any accrued coupons at present value) minus the forward price discounted to that point in time.
So you entered into an agreement to buy at FP but rates have changed in the meantime, which affect prices. So you want to see how your original “bet” or forward agreement compares to today’s reality.
Note that there is no realized profit/loss until forward matures but you can always keep an eye to see how you are doing. That is the purpose of valuation.