How to Calculate Initial Value of Forward Contract
Forward contracts are agreements between two parties to buy or sell an asset at a future date for a predetermined price. This type of contract is commonly used by businesses and investors to protect against market fluctuations. To properly enter into a forward contract, it is essential to calculate the initial value of the contract.
Calculating the initial value of a forward contract involves two primary factors: the current market value of the asset and the future value of the asset at the contract`s expiration date. Additionally, the interest rates for both parties involved need to be taken into account.
To calculate the initial value of a forward contract, you first need to determine the current market value of the asset, also known as the spot price. The spot price is the actual price of the asset at the present time. For example, if you are entering into a forward contract to buy a stock, you need to determine the current market price of that stock.
The next step is to calculate the future value of the asset at the expiration date of the contract. To do this, you need to consider the expected future price of the asset by analyzing the market trends. If you are entering into a forward contract for a stock, you may need to perform technical analysis or consider company news and events to predict the future price of the stock.
Once you have determined the spot price and the expected future price of the asset, you can calculate the forward price, which is the agreed-upon price in the forward contract. The forward price is calculated by adding the expected future price of the asset to the cost of carrying the asset for the period of the contract.
The cost of carrying the asset includes factors such as interest rates, storage costs, and the cost of insurance. Interest rates are a crucial component of the cost of carrying the asset, as they determine the opportunity cost of holding the asset.
To calculate the cost of carrying the asset, both parties need to agree on a benchmark interest rate, such as the LIBOR rate or the Treasury Bill rate. The cost of carrying the asset is then calculated by multiplying the benchmark interest rate by the expected future price of the asset and the number of days until the expiration of the contract.
Once you have calculated the forward price and the cost of carrying the asset, you can then determine the initial value of the forward contract. The initial value of the forward contract is the difference between the forward price and the spot price, minus the cost of carrying the asset.
In conclusion, calculating the initial value of a forward contract involves analyzing the current market value of the asset, predicting the future value of the asset, and factoring in the cost of carrying the asset. Properly calculating the initial value of a forward contract is essential for ensuring a fair and equitable agreement between both parties.
Posted: April 18th, 2022 under Uncategorized.