In class, it is said that a new forward contract should always have zero value because...

In class, it is said that a new forward contract should always have zero value because the initial delivery price is set to the forward price. However, sometimes banks need to structure forward contracts to have nonzero values. They make a forward contract valuable by setting the delivery price different from the forward price. The following problem gives such a situation.

(a) On February 15, a company enters a forward contract with a bank to sell 500,000 euros in six months. The spot price of the euro is $.98/euro, and the euro pays a foreign interest rate of 3%. The domestic interest rate on dollar is 5%. The delivery price is set so that the contract has zero value. What is the delivery price of the contract?

(b) On the maturity date, August 15, the spot price of euro is $1.076/euro, and both domestic and foreign interest rates remain unchanged. What is the profit or loss of the company from each euro in this contract? What is the profit or loss of the bank from each euro in this contract?

(c) On August 15, the company asks the bank if the forward contract can be rolled for another six months. When rolling the contract, no money changes hands between the bank and the company. The bank agrees to do so but needs to set a new delivery price, which does not need to be the forward price in the market. What should be the delivery price that is fair to both the bank and the company?

Expert Solution

I have provided step by step answers based on IRPT theory.

jeff jeffy answered 1 year ago

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