Concept of forward and future contracts.

[abhishek siwach]

Hey all,
Can you please elaborate on the following line a bit more :
" Future contracts and Forward contracts are priced to have zero value at the time an investor enters into the contract". It seems a bit confusing to me. As I think that this line can be very important, I would like you to help me out the basic underlying principle and insights into this statement.

 

[ShaktiRathore]

Hi,
Here there is concept of arbitrage,if the Future contracts and Forward contracts are not priced to have zero value then the arbitrageur can step in and can exploit the opportunity thereby making a riskless profit. You can refer to cash and carry model example. Suppose the F0=S0*exp(rT)=100*exp(.05*1)=105.13 if the Forward price is actually F0=106 then the value of the contract today is 106*exp(-.05*1)-100= $.8303. That is the arbitrageur can short the expensive forward at 106 and borrow 100 to buy the asset today at rate 5% for 1 year so that after 1 year the net cashflow is 106-100*exp(.05*1) or 106*exp(-.05*1)-100 in present value terms=$.8303.IF Forward contracts are priced to have zero value at the time an investor enters into the contract then F0*exp(-.05*1)-100=0 =>F0=100*exp(.05*1)

thanks

 

[JulioFRM]

Hi, are forward contracts only for companies or can a person like you and me enter into a forward contract? what about other type of derivatives (options, futures)? Thanks.

 

[David Harper CFA FRM]

Hi @JulioFRM I could be wrong but we've been taught that a forward is specific type of bilateral contract between two counterparties. Therefore, it seems to me that, for example, nothing is stopping you and I from entering into a forward contract (let's say: I will deliver 20 Litecoins, LTC, to you on Jan 1st 2019 in exchange for $1,200? Who can stop us from this forward contract? ... I would imagine there are startups who will allow us to use a blockchain smartcontract to manage such a transaction, even as we speak). Many derivatives are fundamentally bilateral contracts; nothing us is stopping me from writing you a call option on some reference asset. Of course, at least one of us incurs counterparty risk. (This is not to suggest we are therefore part of the OTC market, much of which is increasingly regulated). Thanks,