Forward Price

What is Forward Price?

Forward price can be defined as a forecasted delivery price of an underlying financial asset, or in other words, it is a price at which an underlying financial asset or commodity is delivered by a supplier to the customer of a forward contract and it is entirely based upon the spot price of an underlying financial asset that includes carrying costs like foregone costs, interest, etc.

Explanation

This is used in a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more for enabling the physical delivery of an underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more or a commodity. The price is paid by the seller to the customer of the forward contract at a pre-decided period against the delivery of an underlying asset or an item. It can be calculated by adding up the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more with carrying costs like rate of interests, expenses about the storage of goods, etc.

Forward-Price

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For eg:
Source: Forward Price (wallstreetmojo.com)

Forward Price Formula

The formulas used for the calculation of the forward price of financial security depends on the fact whether it has no income, known cash income, or known dividend yield. The formulas used for the determination of financial security in each case are:

With no income is, it is –

F = S0erT

With known cash income, the formula is-

F = (S0 – I) erT

With known dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read more is, the formula is-

F = S0e(r-q)T

Where,

Assumptions

How to Calculate?

It can be calculated for each scenario using the following steps-

  1. Steps to follow when there is no income –
    • In the first step, the users will need to identify the financial security’s ongoing spot price (S0 )
    • In the next step, the users will need to identify the irrational arithmetical costs (e)
    • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
    • The users will need to take all the values and place them in the formula (F = S0erT) to find the forward rate of financial security with no income.
  2. Steps to following when there is known income –
    • In the first step, the users will need to identify the financial security’s ongoing spot price (S0 )
    • In the next step, the users will need to identify the P.V. of the cash income (I)
    • Next, the users will need to identify the irrational arithmetical costs (e)
    • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
    • The users will need to take all the values and place them in the formula (F = (S0 – I) erT) to find the forward rate of the financial security with known income.
  3. Steps to follow when there is dividend yield –
    • In the first step, the users will need to identify the financial security’s ongoing spot price (S0 )
    • In the next step, the users will need to identify the rate of dividend yield (q)
    • Next, the users will need to identify the irrational arithmetical costs (e)
    • Next, the users will need to identify the risk-free rate of interest (r) and the delivery date expressed in years (t)
    • The users will need to take all the values and place them in the formula (F = S0e(r-q)T) to find the forward rate of the financial security with known dividend yield.

Examples

A Limited and B Limited entered into a 5-month forward contract to trade a bond at $60. The five-month risk-free rate of interest upon this bond is 6 percent per annum.

Solution:

  • S0 or Spot Rate = $60
  • R or risk-free rate of interest = 6 % p.a.
  • T or the maturity term = 5 months or 0.417.
F = S0erT
  • = 60 * e (0.06 * 0.417)
  • = 60 * 1.025336
  • = $61.52

Therefore, the FP is $61.52

Forward Price vs. Future Price

The forward price must not be confused with future prices. The forward price is concerned with the physical delivery of an underlying financial asset, commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more, security or a currency whereas future prices can be defined as a price of a commodity or stock in a futures contract. Forward price represents the supply and demand for a particular type of commodity whereas future price represents the international supply and demand.

Conclusion

This is usually evaluated on the recent spot price of an underlying financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more, commodity, security or a currency inclusive of carrying costs that may include costs pertaining to storage, foregone interest, rate of interest, opportunity costs, etc.

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