Price Forward contract

CFA Level II
#1

Dear All:

FP = So (1+ Risk free) ^t

It is simply the future value of spot rate, why don’t adjust the Risk free instead of being to the power of T.

For example Rf = 10% and time to maturity is 6 month , then divide the 10% by 2 , instead of taking the power of t=1/2

Thank you so much for your time.

#2

That… that is not how math works…

#3

Lol ohai…

You cannot simply divide by 2, because that would not capture the compounding interest aspect.

#4

As SKWAK88 put, if you dont raise it to the power of “T” you are missing out on the compouding interest effect. If it were just a simple simple interest then you would use the formula you suggested.

#5

if I have 100 one year from now and the interest rate 10%. if I discount it back to present ,then PV= 100/(1+0.1). My question is that if I discount back only 6 months. so the PV= 100/(1.05) or 100/(1.1)^1/2.

Thank you so much

#6

Hi passcfaforsure, Below is the formula and the parameters definition. So look carefully.

PV \ = \ \frac{FV}{(1+i)^n}
1. PV is the value at time=0 2. FV is the value at time=n 3. i is the [discount rate](http://en.wikipedia.org/wiki/Discount_rate "Discount rate"), or the interest rate at which the amount will be compounded each period 4. n is the number of periods (not necessarily an integer)

As you can see from the above formula, from your eg. i = 10% in your case and n = 6months/12months = 0.5 in your case.

That is - if you assume 10% to be annual(12 months) => your compunding period is 12months => n = 6/12=0.5

I hope this clears your doubt.

Link used: http://en.wikipedia.org/wiki/Time_value_of_money