Finance Homework: Analyzing Forward and Futures Contract Pricing

This finance assignment delves into the intricacies of forward and futures contracts, examining the differences in pricing and the factors influencing these variations. It highlights the customized nature of forward contracts versus the standardized structure of futures, emphasizing the impact on pricing and risk management. The solution discusses credit risk, market risk, and the time value of money as key determinants in contract valuation. Furthermore, it justifies the selection of forward contracts for managing financial risk, citing their customization, long-term hedging capabilities, and accounting benefits. The assignment provides insights into strategic financial decisions, offering a comprehensive analysis of contract selection in risk management scenarios, and is available on Desklib, a platform offering a wealth of study resources for students.

Running head: FINANCE
Finance
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
In Response to Question 1..........................................................................................................2
In Response to Question 2..........................................................................................................4
Reference....................................................................................................................................5

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In Response to Question 1
a)
The difference as calculated between the forward and the future price is due to the
specific characteristics and components involved in futures a forward contract. However, it
should be noted that both the futures and forward price should have equal parameters based
on fair value calculations. The price of a forward contract is the rate (F) determined by the
no-arbitrage principle. Suppose in the above example the spot price given is $49 and the
forward price is $52 and the time period for the contract is 6 months. The formula for
determining the forward price is:
F=So*(1+r)^t
Where, 52= 49(1+r)^(6/12)
Reverse Engineering: r = 12.61974%
Now: 49*(1.1261974)^(6/12) = 52
Price of the Forward Contract: $3 (52-49)
Whereas in case of Future Contract:
Ft: So*e^ (rt-q)*(t-t)
49+1.55 = 50.55
Reverse Engineering: rt= 6.42659%
Now: 49*(1.0642659)^(6/12)
Ft= 50.55

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The additional difference which was found in the forward and the future contract are based
on the following points:
 Forward Contract are highly customised contract where the contracts are designed and
priced accordingly to the needs and demands of the parties whereas in the case of the
future prices are standardised contract and are having a common terms and conditions
for the trading in the contract. The pricing for both he forward and the futures contract
is influenced because of this factors.
 Credit risk and market risk is the other factor which plays an important role in this
context where the forward contract suffers from additional credit risk as there is no
exchange or control between the two parties there is a huge credit risk problem in the
forward contract as the same is not marked to market or re-pricing is not done. In
forward contract the valuation is done at the end of the term where the exposure to
one party can be huge and the chances for credit risk increase at that time often.
Whereas, futures contract are daily mark to market so daily settlement of pricing is
done which reduces the credit risk.
 Time value of money is the other important factor to be considered while deciding
between the pricing and valuation of the forward and the future contract.
If both the future and the forward price are at $52 it implies that if the price of the oil in 6
months follows a lognormal distribution and the return of the same follows an normal
distribution it is the best possible price of an asset class after 6 month of time. However, it is
crucial to note that the asset price in the future s simply determined by the formula
F=So*(1+r)^t. The same principle and logic applies in the pricing of the contract. However if
the volatility and macro-economic and risk factors changes the return factor which follows an

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normal distribution can show huge dispersion from its mean level (Ahmadi, & Ariankia,
2017).
In Response to Question 2
The main reason for selecting forward contract rather than option in managing the
financial risk is due to the characteristics of the forward contract. Since, Forward Contract are
highly customised contract where the contracts are designed and priced accordingly to the
needs and demands of the financial risk managers where they prefer long term hedging
contract. The use of forward contract does not have a burden for them for re-pricing and
rechecking again and again. The risk managers use the forward contract to get shelter in case
of extreme price movement of the underlying asset where they are concerned in the long term
pricing and valuation. The risk managers deploys strategy where in the forward contract they
get hedged and they don’t have to pay even premium on the same whereas in the case of
option it is standardised and re-pricing is often and premium is usually paid at the starting of
the contract.
Forward contract use allow the financial managers gives them the benefit of not
showing the exposure in the financial statements of an company as the same will be shown at
the termination of the contract and the profit/loss gained from the contract will be determined
at the end of the period. Whereas in case of option the same profit/loss will be reflected in the
financial statement of the company and the same will make the financial statements more
volatile and sceptical to market and credit risk factors (Jamshidi, Kebriaei & Sheikh-El-
Eslami, 2018).

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Reference
Ahmadi, R., & Ariankia, N. (2017). American Option Pricing of Future Contracts in an Effort
to Investigate Trading Strategies; Evidence from North Sea Oil Exchange.
Jamshidi, M., Kebriaei, H., & Sheikh-El-Eslami, M. K. (2018). An interval-based stochastic
dominance approach for decision making in forward contracts of electricity
market. Energy, 158, 383-395.