for a forward contract on an asset that has no cost or benefit from holding it to have zero value at initiation the arbitrage free forward price must equal:
the answer is future value of current spot price, can someone explain how? bec i thought it is PV of expected future spot price
Forward price is what you need to pay/receive on the settlement date.
The process is like this:
T=0, two parties decide to buy or sell an asset on a specified future day at a price agreed on. This price is forward price.
T=settlement date, one party sell the asset to the other at the specified forward price.
Thus, it should be the FV of the current price.
Theoretically arbitrage will force the forward price = Future of spot.
Spot (let’s say a share) = $100 r= 10% F(o,T) = 100 x 1.1 = $110.
If Fwd price = $120 - too high!
Short forward.
Borrow $100 now and buy share
At expiry of forward deliver share to settle forward receive $120
repay loan 100 x 1.10 = $110
$10 gain !!
If Fwd price = $105 - too low!
Long forward.
Short share and receive $100 and invest at 10% = $110
At expiry of forward pay $105 for share and use share received to cover short.
Still have $5 left. $5 gain !!