Suppose on 31-Dec-2019 you entered into a forward contract to buy one share of stock XYZ...

Suppose on 31-Dec-2019 you entered into a forward contract to buy one share of stock XYZ for delivery price = L = $50 with delivery date 31-Dec-2020. You enter t and S(t) into your formula for V(S,t) to figure out today’s value of the contract. Now suppose you learn to your surprise that interest rates are not constant; they can change in an uncertain way over the time period from today to 31-Dec-2020.

[A] Assume that today’s stock price and the interest rates that prevail today have not changed. Will the forward price that you compute today (for delivery date 31-Dec-2020) change because of your revised view that future interest rates are uncertain?

[B] Will V(S,t), the value of the forward contract, change? Why or why not?

Expert Solution

[A] Answer:

Since the formula for calculating fair value of a forward contracts is

F = S ( 1 + i )^t Where F = the fair price of the Forward Contract, S = current market price of the underlying, i = interest rate, and t = time to expiration

This formula considers that interest rates will remain same till the expiration of the forward contract, but in a situation of uncertain interest rate the formula will not give the exact value of the forward contract.

Still there is no other method to compensate for that uncertainty and the investor or hedger will have to take the risk that is inherent in the pricing of the forward contract.

Even after knowing the fact that the interest rate are not certain we will consider the prevailing rate of intereset in caculating the fair value of the forward contract. Any adverse or favourable change in interest rates will result in loss or profit situation for the two parties involved in the forward contract.

[B] Answer: Value of the forward contract will not change at the present moment but at the time of any change in the interst rates in future the new value of the interest rates will change the value of the forward contract and upon settling the contract the investor may realize profit or loss based on the direction of the interest rates as the underlying value will also change with change in interest rates.

jeff jeffy answered 1 year ago

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