CFAI Book 6, Page 50 Question 3, Part D: This portion of the question asks us to calculate the value of the forward at expiration, which I understand. MY PROBLEM: This question also asks us to calculate the overall gain or loss to the investor on the whole transaction. Why is this not simply the value of the forward? The answer is showing the overall gain or loss on the TRANSACTION as the value of the forward at expiration plus the gain or minus the loss on the underlying security. Why is either side of the forward contract concerned at all about the underlying security’s price at maturity, other than to simply calculate the gain or loss on the contract itself? Schweser seems to totally ignore this concept.
Don’t have the material in front of me, however a forward contract is an agreement between two parties to buy (sell) an asset at a specific price at a specific date in the future. Therefore, if at the future date the spot price of the asset is different from the forward price, either the long or short will have a profit/loss. This is computed by taking the spot price - forward price. The overall gain/loss is the difference between spot and forward price. The forward contract itself is nothing but an agreement between two parties - it derives it’s value from the underlying asset.
I thought the G/L on the transaction was the same as the G/L on the contract itself. I know G/L on the contract is: Spot price at settlement - forward price But it seems like there is another aspect I am missing when it comes to calculating G/L on the whole transaction.
transaction = long asset + short forward contract = forward they calc G/L from bought asset and G/L from sold forward
I figured it out. It was actually somewhat simple. I have to remember that forwards are used to ‘lock in’ gains and losses, i.e. hedge a position. Therefore, the gain or loss on the whole transaction should boil down to the gain or loss locked in at the initiation of the contract. The value of the contract can change, but the value of the transaction should remain the same.