You own a stock priced at €104, and you have a forward contract to sell the stock at €100 in one year. The risk free rate is given by 5 percent per year. What can be said about the value and the price of the forward contract?
A. The value of the forward contract is equal to €-8.76, but its price is €100.
B. The value of the forward contract is equal to €100, but its price is €-8.76.
C. The value of the forward contract as well as its price are both given by €-8.76.
Solution: A. is correct.
- the value of a contract and
- the price of a contract.
The value of a contract is equal to the amount of wealth represented by owning a contract whereas its price is one of the terms the parties agree on when creating the contract.
- We first consider the share price of €104 in period 0.
- This price will be €100 in year T.
- Then, there is a forward contract in period 0,
- it is worth 100/(1 + r + delta) = 100/(1 + 0.05 + 0) = 100/1.05 = €95.2381, because we have a delta equal to zero, since we consider a riskless interest rate.
- So, again, we get €95.2381 when considering the share as well as the forward contract, i.e. the sum of both.
- Therefore, which number do we have to subtract from €104 to get €95.2381? The answer is €8.76.