During this session we reviewed how to price forwards on currencies. Please, have a look at the Excel file. The idea is exactly the same as with other asset classes: if the forward is too expensive (if the forward price should be 1.3062 and it is trading at 1.28 - I can buy less USD for the same amount of EUR), I will sell USD forward; if the forward is too cheap (if the forward price should be 1.3062 and it is trading at 1.32 - I can buy more USD for the same amount of EUR), I will buy USD forward. There is only one no-arbitrage possibility: F = S * e ^ (rd - rf).
Additionally, we had a look at how we should price forwards on consumption assets. In this case, we must take into account any potential convenience yield (for instance, to avoid shortages of the product that could affect our production line) and, also, any storage cost.
Remember the logic behind of the formula:
F = S * e ^ (+ any potential cost - any potential income)
The first day we buy/sell a Forward, the MTM of the position (value) is equal to zero. Remember we do not have to pay anything when we buy/sell a Forward. However, as time goes by and as the underlying asset and interest rates move, the MTM of the Forward will change. Basically, we will compare the price at which we can buy/sell at Maturity with the current Forward price and we will bring the difference to present value.
Finally, in spite of the fact that we will assume both Futures prices and Forward prices to be the same during the course, we reviewed why they are not (correlation between interest rates and price of the underlying asset, different interest rates, credit risk). You can find the presentation here.
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