Title LM05 Pricing and Valuation of Forward Contracts IFT Notes.pdf ✅

LM05 Pricing and Valuation of Forward Contracts 2025 Level I Notes © IFT. All rights reserved 1 LM05 Pricing and Valuation of Forward Contracts 1. Introduction ........................................................................................................................................................... 2 2. Pricing and Valuation of Forward Commitments ................................................................................... 2 Pricing versus Valuation of Forward Contracts ...................................................................................... 2 3. Pricing and Valuation of Interest Rate Forward Contracts ................................................................. 7 Interest Rate Forward Contracts .................................................................................................................. 7 Summary ...................................................................................................................................................................13 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM05 Pricing and Valuation of Forward Contracts 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  How the value and price of a forward contract are determined at initiation, during the life of the contract, and at expiration.  How forward rates are determined from an underlying with a term structure; and their uses. 2. Pricing and Valuation of Forward Commitments Pricing versus Valuation of Forward Contracts Let us take an example. Assume Leo owns a share of GE, whose spot price today (S0) is $100. Rachel enters into a forward contract with Leo today to buy a share of GE at $110 after 1 year. The terms, parties, and ways to settle the contract are described below:  $110 is the forward price; the contract is for a period of 1 year.  Neither Rachel nor Leo pays any money to each other at t = 0 when they enter into the contract.  Rachel is the long party and Leo is the short party.  When the contract expires after 1 year, the forward contract can be settled in two ways: 1) Rachel pays $110 to Leo and receives the share in return; 2) if GE trades at $113 after 1 year, then Leo pays $3 (the difference between the agreed-upon forward price and the current stock price) to Rachel.  There is a risk of default in forward contracts. If the stock price increases to $113, Rachel faces the risk that Leo fails to deliver the share as agreed. Conversely, if the stock price decreases to $99, Leo faces the risk that Rachel does not buy the share as agreed upon.  Is there an alternative way for Rachel to buy this asset? Yes, to wait until time T and buy the asset at its then spot price ST. The drawback is that one cannot be sure what the price of the asset will be then; it may be more, or less. The above example is shown in a generic way in the diagram below. It shows the transactions from a buyer’s perspective at times t = 0 when the contract is initiated and time t = T, when the contract expires.