Module 7 - Valuing Forward Contracts

The PRM Handbook – I.A.
7 Valuing Forward Contracts
I.A.7 Valuing Forward Contracts

Don Chance1
This chapter covers the principles for valuing and pricing forward contracts. It begins by
highlighting the distinction between pricing and valuation of forward contracts in Section I.A.7.1.
The material is then split into two further parts according to the nature of the underlying. Pricing
and valuation principles for forward contracts where the underlying is an asset (such as a stock,
bond, commodity or currency) are covered in Section I.A.7.2. Similar pricing and valuation
principles where the underlying is an interest rate are the topic of Section I.A.7.3.
Within The PRM Handbook there are two other closely related sections covering forward/futures
contracts and markets. Futures and forwards are also discussed in Chapter I.B.3, which focuses
on applications of these important financial instruments. Finally, a discussion of the
characteristics and operation of the market for futures may be found in Chapter I.C.6.
I.A.7.1 The Difference between Pricing and Valuation for

Forward Contracts
In markets for assets such as stocks, bonds, currencies, commodities and options, the price of an
asset is defined as the amount of money that a buyer would pay and a seller would receive to
enter into a transaction in the asset. The value of the asset is the amount of money that a buyer or
seller believes the asset is worth. Value is found by either an assessment of the asset’s expected
cash flows and risk or by comparing the asset’s cash flows to those of an instrument with a
known price and identical cash flows. An asset with a price less (more) than its value is
underpriced (overpriced). In a reasonably well-functioning market, overpriced assets are quickly
sold and underpriced assets are quickly purchased, resulting in a convergence of price to value. In
a truly efficient market, this convergence occurs so rapidly that no single participant can
consistently exploit any discrepancies.
This standard notion of the relationship between price and value, however, fails when we are
dealing with forward contracts, futures contracts and swaps. These instruments are commitments
for one party to purchase and the counterparty to sell an asset for an amount of money agreed
upon at the start.2 These contracts expire at a specific date. The amount of money that will be
1 Don M. Chance, Ph.D., CFA. William H. Wright, Jr. Chair of Financial Services, Department of Finance, 2163
CEBA, Louisiana State University
2 While we refer to these instruments as commitments to purchase an asset, there is no reason why the underlying
cannot be another forward, future or swap, which is not an asset at the start.
Copyright © 2004 D. Chance and the Professional Risk Managers’ International Association 1
The PRM Handbook – I.A.7 Valuing Forward Contracts
exchanged at the expiration date is referred to as the price. This money is not, however, exchanged
at the start of the contract. For that reason, the notion of a price associated with forwards, futures
and swaps is an entirely different concept from the price of an asset, which is indeed exchanged
at the start.
The value of a forward, future or swap is the amount of money that the buyer or seller believes
the contract is worth and represents the amount of money that the buyer would be willing to pay
and the seller would be willing to receive to engage in the contract. That value is obtained by
comparing the cash flows from the contract with those of a transaction with a known price that
produces identical cash flows. The value obtained will then imply a fair price at which a
counterparty should be willing to engage in the contract.
As a result of this different notion of price, the price of a forward, future or swap is typically of
an entirely different order of magnitude than the value of the contract. It will be the case,
however, that, if the price at which a counterparty offers to engage in the contract differs from
the price implied by the value, then the contract is mispriced and an arbitrage opportunity is
available.
Valuation is particularly important given that accounting practice either requires or is likely to
require (depending on the country) that derivatives values be included in financial statements.
Our focus here is on forward contracts, but, as noted, similar principles apply to futures and
swap contracts. We divide the material into two sections, one in which the underlying is an asset,
such as a stock, bond, currency or commodity, and another in which the underlying is an interest
rate.
I.A.7.2 Principles of Pricing and Valuation for Forward Contracts

on Assets
We begin with notation. Consider a forward contract established today at time 0. The contract
expires at time T, which can be interpreted as the number of years, or alternatively T = (days to
expiration/365). The forward price, which is the price agreed upon today, is denoted as F(0,T).
The price of the underlying asset, known as the spot price, is denoted as S0 today and ST at the
expiration date. We shall also be interested in an intermediate time point denoted as time t, where
t = (days until that point in time)/365. The spot price at t is St. We assume that the default-free
interest rate is a constant r, compounded annually.
The forward price is the aforementioned F(0,T). If a new forward contract is created at t to expire
at T, its price would be denoted as F(t,T). A new forward contract created at T to expire at T
would have a price of F(T,T). Such a contract would be equivalent to a spot transaction, however,
so F(T,T) = ST.
The value of a forward contract created at time 0 is V0(0,T). The value of that same contract at t
is Vt(0,T), and its value at T is VT(0,T). Note that a subscript indicates value at a point in time,
while the arguments in parentheses indicate that the contract was created at time 0 and expires at
time T.
The two parties are referred to as the buyer or the long and the seller or the short. We ignore any
credit considerations by assuming that each party is default-free or fully insured at no cost. All
cases assume a forward contract on one unit of the underlying. If the contract covers more than
one unit of the underlying (as is always the case), the value of the contract is multiplied by the
number of units, although the price is typically stated on a per-unit basis. In addition, all results
are obtained from the point of view of the party holding the long position. The forward price is
the same for the long and the short. The value for the short is minus one times the value for the
long.
I.A.7.2.1 The Value at Time 0 of a Forward Contract

Because no money changes hands at the time the forward contract is created (time 0), the value at
time zero has to be zero. Hence, we obtain our first result:
V0(0,T) = 0 (I.A.7.1)
If a party perceives that the contract has a value other than zero, it would engage in the contract
and capture a gain equal to the non-zero value. To obtain a value of zero, however, the forward
contract price must be a specific amount. We determine the appropriate forward contract price in
Section I.A.7.2.5.
I.A.7.2.2 The Value at Expiration of a Forward Contract on an Asset

At expiration, the spot price is ST. The long holds a contract requiring purchase of the asset
worth ST at a price of F(0,T). The value to the long is, therefore,
VT(0,T) = ST – F(0,T) (I.A.7.2)
For example, if the long were obligated to purchase an asset for $100 and the asset is selling for
$105, the contract is worth $5 to the long. The long should be able to sell the contract for $5,
pledge it as $5 of collateral or engage in the transaction adding $5 of value to its net worth.
I.A.7.2.3 The Value Prior to Expiration of a Forward Contract on an Asset

As we have seen, it is a simple matter to determine the value of a forward contract at the time it
is initiated and at expiration. It is slightly more difficult to determine its value during the life of
the contract.
Suppose we are now at time t, part of the way through the life of the contract. We can determine
the value of the forward contract at t if we can find an alternative transaction that is guaranteed
to produce the same outcome at time T as the forward contract. Suppose at time t, we purchase
the asset and borrow F(0,T) using a discount loan. The cost of this transaction is St – F(0,T)(1 +
r)–(T–t), which can also be viewed as the value of the transaction of buying the asset and borrowing
at T. At time T, we will be holding an asset worth ST and will owe the amount F(0,T). This is the
same as the value of the forward contract at time T. Hence, the value of the forward contract at
time t is the same as the value of the transaction of buying the asset and borrowing F(0,T). Thus,
Vt (0,T) = St – F(0,T)(1 + r)–(T–t) (I.A.7.3)
Note that equation (I.A.7.2) is the same as I.A.7.3 when t = T. That is, when we let t go all the
way to T, our valuation formula (I.A.7.3) converges to the simple formula (I.A.7.2). As we shall
see, our formula for the value at time 0, equation (I.A.7.1), is a special case of equation (I.A.7.3).
I.A.7.2.4 The Value of a Forward Contract on an Asset when there are Cash Flows
on the Asset during the Life of the Contract
In the example above, the underlying asset generated no cash inflows or outflows, nor did it incur
any explicit holding costs. Many assets generate cash inflows or outflows. Most stocks pay
dividends, most bonds pay interest, and all currencies pay interest, however little it may be at
times. While these assets typically do not generate significant costs to holding them, most
commodities do incur such costs. In addition, some assets, particularly certain commodities,
generate certain non-monetary benefits.
The explicit and implicit costs associated with holding an asset will affect the arguments
presented above. For example, let us consider an asset such as a stock or bond that makes cash
payments (dividends for stocks, coupons for bonds). These cash payments have a present value
at time t of C(t,T). Interpret this variable as the present value at time t of the cash payments over
the period from t to T. Let us return to our argument that buying the asset and borrowing F(0,T)
at t replicates the value of the forward contract at T. Now it no longer does. The holder of the
asset will not only have the asset worth ST but will also have C(t,T)(1 + r)T–t, which can be
interpreted as the value at T of the cash payments collected and reinvested in the risk-free asset
over the period from t to T.
To recover the correct valuation formula, let us alter our strategy slightly. At time t, we borrow
C(t,T) as well as F(0,T)(1 + r)–(T–t). So the value of this strategy at t is
St – C(t,T) – F(0,T)(1 + r)–(T–t)
At time T, we shall have ST (the asset price) + C(t,T)(1 + r)T–t (the accumulated and reinvested
cash payments) – C(t,T)(1 + r)T–t (the repayment of one loan) – F(0,T) (the repayment of the
other loan), which equals ST – F(0,T) and now equates to the value of the forward contract. Thus,
when the underlying is an asset that makes cash payments,
Vt(0,T) = St – C(t,T) – F(0,T)(1 + r)–(T–t) (I.A.7.4)
The formula for the value at time 0, equation (I.A.7.1), is not altered by the presence of these
cash payments. The value of the contract is zero at the start, because no money changes hands,
whether these cash payments are made or not. At expiration, the value formula, equation
(I.A.7.2), is the same because there are no cash payments remaining.
If the underlying is a currency, we typically capture the information in the cash payments in the
form of a foreign interest rate, which we denote as rf. Now note that, at time T, the party buying
the currency and borrowing at time t will have not one unit of the currency but (1 + rf)T–t units of
the currency. Thus, the value of this strategy at T will be ST(1 + rf)T–t F(0,T). Naturally, this
value exceeds that of the forward contract at T. If we alter the strategy at t so that instead of
buying one unit of the asset, we buy (1 + rf)-(T–t) units, we shall have
(1 + rf)–(T–t)ST(1 + rf)T–t F(0,T) = ST – F(0,T),
which now matches the value of the forward contract at expiration. Thus, the value of a currency
forward contract at t is as follows: When the underlying is a currency that pays interest at the rate rf,
Vt(0,T) = St(1 + rf)–(T–t) –F(0,T)(1 + r)–(T–t) (I.A.7.5)
As in the case of stocks and bonds, the values at times 0 and T are not affected by interest on the
currency.
Now suppose the underlying is a commodity that incurs storage costs. Let us define these costs
in terms of a known amount that has a present value at t of ƣ(t,T) (the Greek letter gamma). At
time T, these costs will have a value of ƣ(t,T)(1 + r)T–t. This value, ƣ(t,T)(1 + r)T–t, can be viewed
as the amount of money expended for storage (including the interest forgone) over the period
from t to T. The strategy we described at time t will now produce a value at T of ST ƣ(t,T)(1 +
r)T–t F(0,T), which differs from the value of the forward contract at T. Now we must alter the
strategy at t to add an investment in the risk-free bond in the amount of ƣ(t,T). Then at T, the
value of the strategy is ST (from the asset) ƣ(t,T)(1 + r)T–t (the accumulated storage costs on the
asset) + ƣ(t,T)(1 + r)T–t (the payoff of the risk-free bond) F(0,T) (the payment of the loan) = ST
– F(0,T), which now matches the value of the forward contract. So this strategy replicates the
forward contract on the commodity. Thus, its value is the same as the value of the forward
contract at t: When the underlying is a commodity that incurs storage costs,
Vt(0,T) = St + ƣ(t,T) –F(0,T)(1 + r)–(T–t) (I.A.7.6)
Note how equation (I.A.7.6) can be linked to equation (I.A.7.4), the valuation formula when
there are cash flows. If there are positive cash flows, we typically refer to them as dividends or
coupons and, accordingly, we obtain equation (I.A.7.4). Negative cash flows are referred to as
holding costs and lead to equation (I.A.7.6). But there is technically no reason why a single
formula would not apply in both cases. The sign of the cash flows could be positive (for
dividends or coupons) or negative (for holding costs). But for convenience and distinction, we
shall use separate formulae.
Finally, we must note that some commodities pay an implicit return known as a convenience
yield. The convenience yield is a concept not very well understood but is thought to represent a
form of non-pecuniary return often occurring in markets with shortages. Loosely speaking, the
convenience yield is a form of a premium earned by holders of assets in short supply. It is a
simple matter to incorporate a convenience yield into equation (I.A.7.6). We merely redefine the
storage cost ƣ(t,T) to be the storage cost net of convenience yield. In some cases, the convenience
yield could exceed the storage cost, giving ƣ(t,T) a negative sign and making equation (I.A.7.6)
more like equation (I.A.7.4).
Again, the values of the forward contract at times 0 and T are unaffected by the presence of
storage costs and a convenience yield.
I.A.7.2.5 Establishing the Price of a Forward Contract on an Asset

Having determined the value of a forward contract at various times during its life, we can easily
determine the price, F(0,T), established when the contract is initiated. Returning to the simple
case of no cash flows or storage costs, we know that the value of a forward contract at time t is
given by equation (I.A.7.3). We know that at time 0, however, no money changes hands and the
value must be zero, as indicated in equation (I.A.7.1). Thus, these two equations must be equal.
Setting t to 0, equation (I.A.7.3) to 0 and solving for F(0,T), we obtain
F(0,T) = S0(1 + r)T (I.A.7.7)
The forward price for the contract is thus set at the compound future value of the spot price.
A somewhat more typical approach to solving for F(0,T) is simply to propose that an individual
purchase the asset at time 0 and sell a forward contract. This transaction will guarantee that at T
the individual will receive F(0,T) for the asset. This transaction is, therefore, risk-free so the
future payoff of the asset must provide for a return equal to the risk-free rate. Hence, F(0,T)
must equal S0(1 + r)T.
If a party would enter into a long position in a forward contract at a price in excess of S0(1 + r)T,
the counterparty going short will earn more than the risk-free rate. The short could borrow the
funds at the risk-free rate, buy the asset and earn an infinite profit at no risk. The demand for
short positions in forward contracts would be infinite, driving the market price down until it
equals S0(1 + r)T. Similarly, if a participant would sell a contract at a price below S0(1 + r)T, other
parties would buy the contract and sell short the asset, creating a synthetic risk-free loan that
would cost less than the risk-free rate. The funds could be invested to earn the risk-free rate,
leading to an infinite rate of return, infinite demand for long positions in the forward contract
and an ensuing increase in the market price of the forward contract until it equalled S0(1 + r)T.
A similar line of reasoning can be applied to the cases in which the underlying pays dividends,
coupons or foreign interest, or incurs storage costs. The resulting forward prices are, when the
underlying pays dividends or coupons,
F(0,T) = (S0 – C(0,T))(1 + r)T (I.A.7.8)
When the underlying is a currency that pays interest at the rate rf,
F(0,T) = S0(1 + rf)–T (1 + r)T (I.A.7.9)
When the underlying is a commodity that incurs storage costs,

F(0,T) = (S0 + ƣ(0,T))(1 + r)T (I.A.7.10)
In general, these formulae can be characterised as the spot price, net of any benefits or plus any
costs, compounded at the risk-free rate over the life of the contract.
I.A.7.2.6 Pricing and Valuation when the Cash Flows or Holding Costs are
Continuous
In some circumstances, it is best to work with continuous rates.3 The continuously compounded
interest rate, which we denote as rc, is the rate at which interest grows when compounded an
infinite number of times during a finite period. This rate is found as the simple logarithmic
transformation of the discrete rate r, that is
3 See the discussion of discrete versus continuous compounding methods in Chapter I.B.1.
rc = ln(1 + r)
When interest is compounded continuously, our preceding formulae are slightly adjusted. For
example, the formulae for the forward price established at time 0 and value at time t when the
asset has no cash flows or costs are
c
F ( 0, T ) S0e r T
c
V t ( 0, T ) S t F ( 0, T )e r ( T t )
When the underlying generates cash flows, it is common to use C(0,T) as the present value of the
cash flows when these cash flows are in the form of bond coupons. In that case our formulae
would be
c
F ( 0, T ) ( S 0 C ( 0, T ))e r T
c
V t ( 0, T ) S t C ( t , T ) F ( 0, T )e r ( T t )
When the underlying is a stock, we could use C(t,T) as above, but it is more typical to incorporate
the continuously compounded dividend yield, which we denote as Ƥc. In that case, we must
remove the value of the dividends from the stock price, an operation performed by discounting
the stock price at the dividend yield rate over the contract life. Thus, our price and valuation
formulae become
c c c
Ƥ c )T
F ( 0, T ) S 0 e Ƥ T e r T S0e (r
c c
(I.A.7.11)
V t ( 0, T ) S t e Ƥ ( T t ) F ( 0, T )e r ( T t )
When the underlying is a currency, we simply use the continuously compounded foreign rate,
c
which we denote as rf . Then our formulae become
r f c T r c T ( r c r f c )T
F ( 0, T ) S0e e S0e
r f c ( T t ) c
V t ( 0, T ) St e F ( 0, T )e r ( T t )
Note the similarity between the formulae for a forward contract on a currency with foreign
c
interest rate rf and those for a forward contract on a stock with dividend yield Ƥc. The foreign
interest rate and dividend yield play the same role. This result should make sense. The foreign
interest rate and the dividend yield are the rates at which their respective underlyings generate
positive cash flows.
When the underlying is a commodity with storage costs, we can continue to use the measure of
storage costs ƣ(0,T) at time 0 and ƣ(t,T) at time t. In that case, the formulae become
c
F ( 0, T ) ( S 0 ƣ( 0, T ))e r T
c
V t ( 0, T ) S t ƣ( t , T ) F ( 0, T )e r ( T t )
Alternatively, we might prefer a continuously compounded measure of the rate at which storage
costs accrue. Denoting this parameter as ƫ, our formulae would be
c c
ƫ )T
F ( 0, T ) S 0 e ƫT e r T S0e ( r
c
V t ( 0, T ) S t e ƫ ( T t ) F ( 0 , T )e r ( T t )
In this case, note how the storage cost rate ƫ is added to the risk-free rate to determine the
forward price. The intuition is simple: interest is a form of storage cost, representing the
opportunity cost of funds tied up in the asset. The rates r and ƫ constitute the total cost forgone
in holding the asset.
I.A.7.2.7 Numerical Examples

In this section, we present some numerical examples. All cases involve discrete compounding.
Conversion to the continuous case can be done easily by adjusting the rates and measuring the
costs and cash flows with continuous compounding and discounting.
We take as the standard case an asset priced at €100. The discrete risk-free rate is 4%. We are
interested in a forward contract expiring in three years. Thus, S0 = 100, r = 0.04, and T = 3. We
shall find the forward price, which is set at time 0. Then we shall move forward one year to time t
= 1, where we observe a spot price of €100 = 115.50, and find the contract value. We assume the
contract calls for delivery of one unit of the underlying.
Case 1. No cash flows or costs on the underlying

The forward price is easily found as follows:
F ( 0, T ) S 0 ( 1 r )T
F ( 0,3 ) 100 u 1.04 3
112.49
Now, moving forward to time 1, the forward contract value is found as
V t ( 0, T ) S t F ( 0, T )(1 r ) ( T t )
V1 ( 0 , 3 ) S 1 F ( 0,3 )(1 r ) ( 31)
115.50 112.49 u 1.04 2
11.50
Case 2. Cash flows on the underlying

Now let us assume that the underlying pays cash (dividends or interest) of €2.50 at times 1, 2 and
3. We must first find the present value at time 0:
C(0,T) = C(0,3) = 2.50 × 1.04–1 + 2.50 × 1.04–2 + 2.50 × 1.04–3 = 6.94
The forward price would be
F ( 0, T ) ( S 0 C ( 0, T ))(1 r )T
F ( 0,3 ) ( S 0 C ( 0,3 ))(1 r ) 3
(100 6.94 ) u 1.04 3
104.68
To obtain the value at time 3, we must find the new present value of the cash flows as of time 1.
Assuming the cash flow at time 1 is already paid, we obtain C(1,3) as
C(t,T) = C(1,3) = 2.50 × 1.04–1 + 2.50 × 1.04–2 = 4.72
The value of the forward contract at time 1 is, therefore,
V t ( 0, T ) S t C ( t , T ) F ( 0, T )(1 r ) ( T t )
V1 ( 0 , 3 ) S 1 C (1,3 ) F ( 0,3 )(1 r ) ( 31)
115.50 4.72 104.68 u 1.04 2
14.00
Case 3. Underlying is a currency

Let the foreign risk-free rate be rf = 0.03. The forward price would be
F ( 0, T ) S 0 ( 1 r f ) T ( 1 r )T
F ( 0, 3 ) S 0 (1 r f ) 3 (1 r ) 3
100 u 1.03 3 u 1.04 3
102.94
At time 1, the value of the contract would be
V t ( 0, T ) S t (1 r f ) ( T t ) F ( 0, T )(1 r ) ( T t )
V1 ( 0 , 3 ) S 1 (1 r f ) ( 31) F ( 0,3 )(1 r ) ( 31)
115.50 u 1.03 2 102.94 u 1.04 2
13.70
Case 4. Underlying is a commodity with storage costs

Assume that the underlying is a commodity that incurs costs of €5 at the end of each year. We
can assume that these costs are net of any convenience yield. The present value of the storage
costs is
ƣ(0,3) = 5 × 1.04–1 + 5 × 1.04–2 + 5 × 1.04–3 = 13.88
The forward price would be
F ( 0, T ) ( S 0 ƣ( 0, T ))(1 r )T
F ( 0,3 ) ( S 0 ƣ( 0,3 ))(1 r )3
(100 13.88 ) u 1.04 3
128.10
Now move forward to time 1. The value of the storage costs is
ƣ(1,3) = 5 × 1.04–1 + 5 × 1.04–2 = 9.43
The value of the forward contract is, therefore,
V t ( 0, T ) S t ƣ( t , T ) F ( 0, T )(1 r ) ( T t )
V1 ( 0 , 3 ) S 1 ƣ(1,3 ) F ( 0,3 )(1 r ) ( 31)
115.50 9.43 128.10 u 1.04 2
6.49
To recap, we have examined the pricing and valuation of forward contracts when the underlying
is an asset. We saw that the forward price is the future value of the spot price after a deduction
for any benefits received on the asset or an increment for any costs incurred on the asset. The
value of a forward contract is always zero today, the spot price minus the forward price at
expiration, and the spot price adjusted for costs and benefits minus the present value of the
forward price any time during the life of the contract.
I.A.7.3 Principles of Pricing and Valuation for Forward Contracts

on Interest Rates
Forward contracts on interest rates are widely used by corporations and financial institutions.
These contracts are known as forward rate agreements (FRAs). The general notion of pricing and
valuation is the same as for contracts on assets, but the steps required to obtain the results are
slightly more complex. First we describe some basic characteristics of FRAs.
An FRA is an agreement between two parties in which one party, the buyer or the long, agrees to
make a known interest payment to the other party, the seller or the short, at a future date, with
the seller agreeing to make an interest payment to the buyer based on an unknown rate that will
be determined when the contract expires. Most FRAs are based on well-established interest rates
such as dollar LIBOR or Euribor. The underlying instrument is a Eurodollar time deposit, a loan
in which the borrower is a high-quality (but not default-free) bank. We shall simply use the term
LIBOR in reference to the underlying rate. An FRA expires in a certain number of months and
the underlying LIBOR is based on a certain number of months. Traders use terminology such as
a ‘6 × 9 FRA’ to describe an FRA that expires in six months with the underlying being three-
month LIBOR. Hence, the ‘9’ refers to the maturity of the underlying Eurodollar time deposit at
the time the contract is created. Six months later when the FRA expires, it is a three-month time
deposit.
The computations require the determination of interest payments and typically rely on the use of
a day count. Let us now redefine our time framework. The FRA is created on day 0 and expires
on day m. The underlying is q-day LIBOR. Let L0(m) be m-day LIBOR on day 0, L0(m + q) be
(m+q)-day LIBOR on day 0, and Lm(q) be q-day LIBOR on day m. Lm(q) is the uncertain rate
revealed on day m that determines the payment from seller to buyer and should be viewed as the
underlying. The fixed payment made by buyer to seller will be denoted as F(0,m,q), representing
the payment determined at day 0 for a contract expiring on day m in which the underlying is q-
day LIBOR. We shall also be interested in the value of the FRA at a particular day during its life,
which we denote as day d.
As in any interest payment, there must be an underlying principal amount on which the interest is
based. This principal amount is called the notional principal. Notional principal is never paid
because it serves no purpose other than to determine the interest payments.4 Our calculations for
the value of the FRA apply to the case of a notional principal of one unit of the currency. If the
4 If notional principal were paid, the parties would merely exchange the same sum of money at the start of the contract
and at the end, which would serve no economic purpose and merely create credit risk where none existed.
notional principal is N units of the currency, we must multiply the value obtained by N. In
addition, the results are derived from the perspective of the party going long. To obtain the value
for the party going short, we simply multiply the value for the party going long by minus one. In
accordance with standard interest calculations, we adjust by a factor to reflect the period of the
underlying. In the LIBOR market, an interest payment at q-day LIBOR would be obtained by
multiplying the rate times days/360.
Finally, let us establish the symbols for the values of the FRA at various times during its life. Let
VFRA0(0,m,q) be the value on day 0 of an FRA established at time 0, expiring at time m, with the
underlying being q-day LIBOR. Let VFRAd(0,m,q) be the value on day d of an FRA established at
time 0, expiring at time m, with the underlying being q-day LIBOR. Let VFRAm(0,m,q) be the
value on day m (expiration) of an FRA established at time 0, expiring at time m, with the
underlying being q-day LIBOR Now we can proceed to determine the value and pricing of an
FRA.
I.A.7.3.1 The Value of an FRA at Expiration

The value of an FRA at expiration is a standard calculation widely used in the industry:
q
L m ( q ) F ( 0 , m , q )
VFRA m ( 0, m , q ) 360 (I.A.7.12)
q
1 L m (q )
360
The term Lm(q) – F(0,m,q) is the difference between the underlying q-day rate determined on day
m, Lm(q), and the rate the parties agreed to on day 0, F(0,m,q). Given that all other terms in
equation (I.A.7.12) are positive, the sign of the equation, which is the value of the FRA to the
long, is positive if Lm(q) exceeds F(0,m,q). In that case, the long receives the payment from the
short. If Lm(q) is less than F(0,m,q), equation (I.A.7.12) is negative, the value of the FRA to the
long is negative, and the payment flows from the short to the long. The denominator to the
equation is an adjustment factor that reflects the fact that the interest rate Lm(q) is determined on
day m in the LIBOR market. In that market, Lm(q) is the rate on a Eurodollar time deposit that
begins on day m and pays the interest q days later. But in the FRA market, the payment at the rate
Lm(q) is determined on day m and paid on day m. Thus, in a sense, this payment is somewhat
premature and, accordingly, is discounted at q-day LIBOR on day m. Naturally all rates are
adjusted by the factor q/360.
So, at the expiration date, the parties exchange the net difference between interest rates adjusted
by the factor q/360 and discounted to reflect the fact that the payment is received earlier than
implied by the underlying rate.
I.A.7.3.2 The Value of an FRA at the Start

At the start of the contract, the value of the FRA has to be zero, because no money changes
hands.
VFRA0(0,m,q) = 0 (I.A.7.13)
Of course, this is the same result we obtained for forward contracts on assets.
I.A.7.3.3 The Value of an FRA During Its Life

To value an FRA during its life, we use the same general approach as when we were valuing a
forward contract on an asset: we position ourselves during the life of the contract and engage in a
transaction that will produce the same value of the contract at expiration. So we now put
ourselves on day d. The information available to us is (m – d)-day LIBOR, denoted as Ld(m – d),
and (m + q – d)-day LIBOR, denoted as Ld(m + q – d).
To replicate the value of the FRA at its expiration, at time d we invest the following amount in a
LIBOR time deposit:
1
§m d ·
1 L d ( m d )¨ ¸
© 360 ¹
This instrument will pay $1 on day m. We also issue a LIBOR time deposit promising to pay 1 +
F(0,m,q)(q/360) on day m + q. This loan will produce upfront cash of
§ q ·
1 F ( 0, m , q )¨ ¸
© 360 ¹
§m q d ·
1 L d ( m q d )¨ ¸
© 360 ¹
On day m, the time deposit we hold is worth $1. The loan has a value of
§ § q ··
¨ 1 F ( 0, m , q )¨ ¸¸
¨ © 360 ¹ ¸
¨ § q · ¸
¨ 1 L m ( q )¨ ¸ ¸
© © 360 ¹ ¹
The total value of the strategy on day m is, therefore,
§ § q ··
¨ 1 F ( 0, m , q )¨ ¸¸
1 ¨ © 360 ¹ ¸
¨ § q · ¸
¨ 1 L m ( q )¨ ¸ ¸
© © 360 ¹ ¹
Using a common denominator, the value of the strategy on day d is
§ q · § § q ··
1 L m ( q )¨ ¸ ¨¨ 1 F ( 0, m , q )¨ ¸ ¸¸
© 360 ¹ © © 360 ¹ ¹
§ q ·
1 L m ( q )¨ ¸
© 360 ¹
§ q ·
( L m ( q ) F ( 0, m , q ))¨ ¸
© 360 ¹
§ q ·
1 L m ( q )¨ ¸
© 360 ¹
which is the value of the FRA, equation (I.A.7.12), at expiration. Thus, on day d, this strategy
replicates the FRA. So its value on day d must be the same as the value of the FRA on day d:
§ q ·
1 F ( 0, m , q )¨ ¸
VFRAd ( 0, m , q )
1
© 360 ¹
(I.A.7.14)
§m d · §m q d ·
1 L d ( m d )¨ ¸ 1 L d ( m q d )¨ ¸
© 360 ¹ © 360 ¹
I.A.7.3.4 Pricing the FRA on Day 0

We know that the value of the FRA on day 0 is zero. We also know that the value of the FRA at
expiration can be replicated by pursuing the strategy described in the previous section on day d.
Now let day d be day 0, restate equation (I.A.7.14) with d = 0, set the equation to zero, and solve
for F(0,m,q) to obtain:
§ §mq· ·
¨ 1 L 0 ( m q )¨ ¸ ¸
F ( 0, m , q ) ¨ © 360 ¹ 1¸§¨ 360 ·¸ (I.A.7.15)
¨ § m · ¸¨© q ¸¹
¨ 1 L 0 ( m )¨ ¸ ¸
© © 360 ¹ ¹
Although this expression looks complex, it is actually quite simple. The numerator of the first
fraction, 1 + L0(m + q)((m + q)/360), contains the compound value of a $1 LIBOR time deposit
of m + q days. The denominator, 1 + L0(m)(m/360), contains the compound value of a $1
LIBOR time deposit of m days. The division of the former by the latter, after subtracting 1, yields
the compound future value of a $1 LIBOR forward time deposit, initiated on day m and maturing
on day m + q. The second fraction, 360/q, simply annualises this rate. Thus, the fixed rate on the
FRA is forward LIBOR.
I.A.7.3.5 Numerical Examples

Now let us illustrate these formulae for an FRA. Consider a 3 × 9 FRA, meaning that the
contract expires in three months (90 days) and the underlying is six-month (180-day) LIBOR.
Assume at time 0, the spot rate is 8% for 90-day LIBOR and 8.5% for 270-day LIBOR. Thus,
our information is as follows: m = 90, q = 180; L0(m) = L0(90) = 0.08; L0(m + q) = L0(270) =
0.085.
The forward price is
§ §mq· ·
¨ 1 L 0 ( m q )¨ ¸ ¸
¨ © 360 ¹ ¸§ 360 ·
F ( 0, m , q ) 1 ¨¨ ¸
¨ § m · ¸© q ¸¹
¨ 1 L 0 ( m )¨ ¸ ¸
© © 360 ¹ ¹
§ § 270 · ·
¨ 1 L 0 ( 270 )¨ ¸ ¸
¨ © 360 ¹ ¸§ 360 ·
1 ¨
¸© 180 ¸¹
F ( 0,90,180 )
¨ § 90 ·
¨ 1 L 0 ( 90 )¨ ¸ ¸
© © 360 ¹ ¹
§ § 270 · ·
¨ 1 .085¨ ¸ ¸
¨ © 360 ¹ 1¸§ 360 ·
¨ § 90 · ¸¨© 180 ¸¹
¨ 1 . 08 ¨ ¸ ¸
© © 360 ¹ ¹
0.0858
Now move 60 days forward. Let the 30-day rate be 9.2% and the 210-day rate be 9%. The
information we have is d = 60, m – d = 90 – 60 = 30, m + q – d = 90 + 180 – 60 = 210; Ld(m – d)
= L60(30) = 0.092; Ld(m + q – d) = L60(210) = 0.09. The value of the FRA per $1 would be
§ q ·
1 F ( 0, m , q ))¨ ¸
VFRAd ( 0, m , q )
1
© 360 ¹
§m d · §m q d ·
1 L d ( m d )¨ ¸ 1 L d ( m q d )¨ ¸
© 360 ¹ © 360 ¹
§ 180 ·
1 .0858¨ ¸
VFRA60 ( 0,90,180 )
1
© 360 ¹
§ 30 · § 210 ·
1 .092¨ ¸ 1 .09¨ ¸
© 360 ¹ © 360 ¹
0.0015
I.A.7.4 The Relationship Between Forward and Futures Prices

Futures contracts are similar to forward contracts but are standardised, guaranteed against
default, and trade in a regulated environment on a futures exchange. Any observed difference
between forward and futures prices is typically attributed to the different cash flow streams of the
two contracts. Futures provide cash flows daily in the form of the daily settlement of gains and
losses, while forward contracts provide cash flows at the end of the life of the contract.
The differences between forward and futures prices for assets have been examined by Cox et al.
(1981) and Jarrow and Oldfield (1981). Summarising their findings, we can say that forward and
futures prices for assets are the same at expiration, or if the contracts have a single day to go
before expiration, or if certain relationships regarding the correlation between futures prices,
forward prices and risk-free bond prices are met. The last condition is best understood by
considering one party holding a forward contract and another holding a futures contract. If
futures prices and interest rates are positively related, the party holding the futures contract will
have an advantage over the party holding the forward contract because gains from daily
settlement will be invested at rising interest rates and losses from daily settlement will be funded
at falling interest rates. The stream of interest rates over the life of the contract will have no
effect on the value of the forward contract at expiration. If futures prices and interest rates are
negatively related, the party holding the futures contract will have a disadvantage over the party
holding the forward contract because gains from daily settlement will be invested at falling
interest rates and losses from daily settlement will be funded at rising interest rates. The party
holding the advantage will be willing to pay a higher price. If futures price and interest rates are
unrelated, neither contract will have an advantage, and forward and futures prices will be equal.5
The difference between forward and futures prices for FRAs relative to Eurodollar futures is
much less clear. A difference does exist and has been examined by Sundaresan (1991), but the
issues are beyond this level of treatment. Credit risk can make futures prices differ from forward
prices, but any such difference will be attributed to a complex mixture of factors such as which
party has the better credit risk and the existence of credit mitigation factors for forward
contracts.6
5 There are a couple of other conditions as well as other ways of stating the necessary conditions for a divergence
between futures and forward prices, but we do not pursue these here.
6 In fact, parties to some forward contracts engage in periodic settlements, rendering the cash flow streams of these
contracts more like those of futures contracts.
References
Cox, JC, Ingersoll, JE, Jr, and Ross, SA (1981) ‘The relation between forward prices and futures
prices’, Journal of Financial Economics, 9 (4), pp. 321–46.
Jarrow, R, and Oldfield, G (1981) ‘Forward contracts and futures contracts’, Journal of Financial
Economics, 9 (4), pp. 373–82.
Sundaresan, S (1991) ‘Futures prices on yields, forward prices, and implied forward prices from
term structure’, Journal of Financial and Quantitative Analysis, 26 (3), pp. 409–24.

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The PRM Handbook – I.A.

7 Valuing Forward Contracts

I.A.7 Valuing Forward Contracts

I.A.7.1 The Difference between Pricing and Valuation for

I.A.7.2 Principles of Pricing and Valuation for Forward Contracts

I.A.7.2.1 The Value at Time 0 of a Forward Contract

I.A.7.2.2 The Value at Expiration of a Forward Contract on an Asset

I.A.7.2.3 The Value Prior to Expiration of a Forward Contract on an Asset

I.A.7.2.5 Establishing the Price of a Forward Contract on an Asset

When the underlying is a commodity that incurs storage costs,

I.A.7.2.7 Numerical Examples

Case 1. No cash flows or costs on the underlying

Now, moving forward to time 1, the forward contract value is found as

Case 2. Cash flows on the underlying

The forward price would be

The value of the forward contract at time 1 is, therefore,

Case 3. Underlying is a currency

At time 1, the value of the contract would be

Case 4. Underlying is a commodity with storage costs

The forward price would be

Now move forward to time 1. The value of the storage costs is

ƣ(1,3) = 5 × 1.04–1 + 5 × 1.04–2 = 9.43

The value of the forward contract is, therefore,

I.A.7.3 Principles of Pricing and Valuation for Forward Contracts

I.A.7.3.1 The Value of an FRA at Expiration

I.A.7.3.2 The Value of an FRA at the Start

I.A.7.3.3 The Value of an FRA During Its Life

The total value of the strategy on day m is, therefore,

Using a common denominator, the value of the strategy on day d is

I.A.7.3.4 Pricing the FRA on Day 0

I.A.7.3.5 Numerical Examples

The forward price is

I.A.7.4 The Relationship Between Forward and Futures Prices

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