Futures and forward contracts are viewed as derivative contracts because their values are derived from an underlying asset. The forward contract is an agreement between two parties, which are buyer and seller and they must fulfil their contractual obligations at a price established at the beginning upon the expiration date, the buyer must pay the agreed price to the seller and the seller must deliver the underlying asset to the buyer. Futures contracts have a similar definition to forward contract but futures contracts are standardized transaction.
Valuation reflects the amount of money to terminate the contract and the market Requirements to valuate these contracts when there is a default on contracts. There are some key differences in the valuations of these contracts. First of all, in case of there was a default on the forward contract, that would required the cash settlement to reduce credit exposure and forward contract risk. The forward price is equal to the spot price doubled at the favourable rate of interest at the time of the maturity date. On other words, it is the present value (PV) which equal to the future value (FV) of spot rate .So, it may traded at a premium or discount to the spot price. Moreover, that will result two position one of them will have a positive valuation, and the other will have a negative valuation. Forward contract value would be varying from market spot price through the life of the contract. On the other hand, the value of futures contract calculates as a number of contracts multiplied by size of contract which also multiplied by daily margin variation which means it not only has a futures price set at time 0 but it also has a new price at time t - 1, at time t, and at time T. Furthermore, Futures contracts valuation has some assumptions such as there is no transaction and transport costs, they do not have any basis, and opportunity cost in hedging non-existent.
When valuing forward contracts, explain how market position determines positive and negative values.
Under a default situation and the credit risk in a forward contract, Market position who determines positive and negative value when valuing forward contract. Valuation of forward contract calculates the credit risk by the cash settlement which would be required when there was a default in the contract. Market has a three types of positions which include long position when it own an asset (equities or funds) or hold an asset, short position if it need to buy equities or borrow funds, and neutral which is the immediate market position for both parties . In case of establish long position in a forward contract with a default short position, and the cash settled the default risk is on the upside that leads to negative value and the gain on the downside. On the other hand,
When makes short position in a forward contract with a default long position, the default risk is on the downside that leads to negative value and the gain on the upside.
When valuing futures contracts, explain how market position determines positive and negative values.
Futures contract value calculated as the number of contracts multiplied by the size of contract and daily margin variation. Because of future contract values based on daily margin, the value at the start of the contract is determined equal to zero, after that the value of the contract at the end of each day would be equal to the value at the end- of- day less the value of the previous day.
Determination the market position in the future market when the investor takes the long position which means buying the futures and that leads to the risk will be in the downside (Debit on downside and Credit on upside). In this situation if the price of the futures increase the buyer will earn profit and in contrast if the price of the futures decreases the buyer will get loses. On the other hand, when the investor take a short position which means selling futures and that result in the risk will be in the upside (Debit on upside and Credit on downside), in this case, if the price of the futures decrease the seller will earn profit and in the opposite, if the price increase he will gets loses .
Using examples to illustrate, what other factors (other than market position) are important when calculating forward and futures contract valuation?
The most important factors when calculating forward and futures contract valuation are time value of money (present value), equities (dividends or cash flows),
Firstly, time value of money (present value) of forward contract which calculates as
At expire date, the difference between the spot price St, F (0, T), the present value of the forward contract price is the basis of the value of the forward contract at time (t) (initiated at time 0 and expire at time T). Other factor is equity (dividends or cash flows) of forward and future contract
Dividends or Cash flows
Forward Contract Valuation
Future Contract Valuation
During the term of the contract with a known dividend yield, an equity forward contract value at time t is equal to the present value of the difference between the price agreed to pay for the asset at time T, F (0, T), and the value of the asset which acquire under the contract at time T, less the present value of the known dividends payable. In addition, during the term of the contract, if the equities have a known cash flow that leads to equity forward contract price is equal to the spot price, less the present value of the known cash flow, added at the appropriate rate of interest for the time to maturity date.
