Forward Contract

The forward price is not a forecast of the future spot price; it is the level that makes an arbitrage between the derivative and a financed spot position impossible. For an asset with no cash flows, the forward price equals the spot price compounded forward at the risk-free rate over the life of the contract. A trader who could buy the forward cheaper than that would borrow, buy the asset today, carry it to expiry, and deliver into the contract for a riskless profit.

Any cost or benefit of holding the asset shifts the result. Storage, insurance and financing costs raise the forward price; dividends, coupons, lease rates or the convenience yield on a physical commodity lower it. In practice the working rule is that the forward price equals the spot price grossed up at the risk-free rate, then adjusted upward for carry costs and downward for the present value of carry benefits.

Price and value are distinct concepts in a forward. The forward price is fixed at inception and never changes; the value of the contract to each party moves continuously as the spot price and the remaining time to maturity change. At initiation the contract is worth zero, which is precisely why no premium is exchanged.

To value a long position part-way through its life, compare the forward price available today on a contract expiring on the same date with the price locked in originally, and discount that difference back at the risk-free rate over the remaining term. If today's forward price is higher, the long position has positive value and the short has an equal and opposite negative value. At expiry there is nothing left to discount, so value collapses to the spot price minus the contracted forward price for the long.

The currency forward market is the deepest application, allowing corporates and asset managers to fix an exchange rate for a specific amount on a specific settlement date. Where currencies are not freely convertible, banks trade non-deliverable forwards that settle the difference in a hard currency rather than exchanging principal. In fixed income, forward rate agreements lock a single interest rate for a future deposit period and cash-settle the difference against the realised reference rate.

Equity forwards on individual shares or indices allow synthetic exposure without an upfront purchase, and commodity forwards let producers and processors fix a delivery price for physical volume. Bond forwards are usually quoted on a clean price, with accrued interest handled separately at settlement.

Because a forward accumulates the entire gain or loss until one settlement date, credit exposure builds through the life of the contract and peaks near expiry. That exposure is bilateral: whichever party is in the money faces the other's default. Post-crisis practice has narrowed this through collateral agreements and, for standardised trades, mandatory central clearing, but the underlying contract remains bespoke and largely illiquid. Closing early usually means negotiating an offsetting trade or a termination payment rather than selling out on an exchange.

At Level I a candidate should be able to compute a forward price from spot under carry, mark an existing forward to market at an interim date, identify the payoff to long and short at settlement, and explain how the absence of daily settlement changes the credit and cash-flow profile.