What is a Forward Price?
Forward price is the predetermined delivery price for an underlying commodity, currency, or financial asset as decided by the buyer and the seller of the forward contract, to be paid at a predetermined date in the future. At the inception of a forward contract, the forward price makes the value of the contract zero, but changes in the price of the underlying will cause the forward price to take on a positive or negative value.
The forward price is determined by the following formula:
1F₀ = S₀ * e^(r * T)
Basics of Forward Price
Forward price is based on the current spot price of the underlying asset, plus any carrying costs such as interest, storage costs, foregone interest, or other costs including opportunity costs.
Although the contract has no intrinsic value at inception, over time, a contract may gain or lose value. Offsetting positions in a forward contract are equivalent to a zero-sum game. For example, if one investor takes a long position in a pork belly forward agreement and another investor takes the short position, any gains in the long position equal the losses that the second investor incurs from the short position. By initially setting the value of the contract to zero, both parties are on equal ground at the inception of the contract.
Key Takeaways
- Forward price is the price at which a seller delivers an underlying asset, financial derivative, or currency to the buyer of a forward contract at a predetermined date.
- It is roughly equal to the spot price plus associated carrying costs such as storage costs, interest rates, etc.
- Investors may want to lock in a forward price to hedge against future market fluctuations.
- The downside of locking in a forward price is that the asset’s value could move unfavorably against the investor.
Forward Price Calculation Example
When the underlying asset in the forward contract does not pay any dividends, the forward price can be calculated using the following formula:
1F = S * e^(r * t)
2where:
3F = the contract's forward price
4S = the underlying asset's current spot price
5e = the mathematical irrational constant approximated by 2.7183
6r = the risk-free rate that applies to the life of the forward contract
7t = the delivery date in years
For example, assume a security is currently trading at $100 per unit. An investor wants to enter into a forward contract that expires in one year. The current annual risk-free interest rate is 6%. Using the above formula, the forward price is calculated as:
1F = $100 * e^(0.06 * 1) = $106.18
If there are carrying costs, they are added into the formula:
1F = S * e^((r + q) * t)
Here, q is the carrying costs.
If the underlying asset pays dividends over the life of the contract, the formula for the forward price is:
1F = (S - D) * e^(r * t)
Here, D equals the sum of each dividend’s present value, given as:
1D = PV(d₁) + PV(d₂) + ... + PV(dₓ) = d₁ * e^-(r * t₁) + d₂ * e^-(r * t₂) + ... + dₓ * e^-(r * tₓ)
Using the example above, assume that the security pays a 50-cent dividend every three months. First, the present value of each dividend is calculated as:
1PV(d₁) = $0.5 * e^-(0.06 * 3/12) = $0.493
2PV(d₂) = $0.5 * e^-(0.06 * 6/12) = $0.485
3PV(d₃) = $0.5 * e^-(0.06 * 9/12) = $0.478
4PV(d₄) = $0.5 * e^-(0.06 * 12/12) = $0.471
The sum of these is $1.927. This amount is then plugged into the dividend-adjusted forward price formula:
1F = ($100 - $1.927) * e^(0.06 * 1) = $104.14
What is the Difference Between Forward Price and Spot Price?
Forward price refers to a predetermined future delivery price for an underlying commodity, currency, or financial asset agreed upon by the buyer and seller of a forward futures contract. In contrast, a spot price refers to the asset’s current market price.
Why Do Some Investors Want to Lock in a Forward Price?
Investors may want to lock in a forward price to hedge against future market fluctuations. For example, a farmer may want to use a forward wheat contract ahead of harvest to protect against a decline in grain prices caused by potential drought or flood.
What are the Drawbacks of Locking in a Forward Price?
The main downside of locking in a forward price is that the asset’s value could move unfavorably against the investor, resulting in a loss compared to selling at the spot price on the asset’s delivery. Furthermore, a longer-dated forward price contract increases the risk of non-payment or default.
What are the Main Factors That Determine an Asset’s Forward Price?
Investors determine an asset’s forward price based on its current spot price plus carrying costs such as storage, transportation, opportunity costs, and foregone interest. Typically, these costs will be higher for forward contracts that have longer expiry dates.
The Bottom Line
Forward price refers to an asset’s future delivery price agreed upon by the buyer and seller of a forward futures contract. This type of contract has zero value at inception as market conditions have yet to change. Investors determine a forward price by adding carrying costs to the underlying asset’s spot price. Using a forward price in futures contracts provides a hedge against market fluctuations; however, this can work as a double-edged sword if an asset’s value moves unfavorably against the investor.
Related Terms: spot price, hedge, financial derivatives, opportunity cost.
