Chapter 4

29 September 2020 03:55 PM

“Price” is the price at which counterparties agree to transact, while “value” is the value of holding a given
position.

Let’s explore the concepts of price and value in the context of a forward:
■ Forward price: The price at which the long forward is obligated to purchase the underlying asset from the
short forward. The forward price is determined at initiation and does not change.
■ Forward value: The value of holding a position in a forward at a given point in time during the life of the
forward.

A forward is designed to have zero value at initiation. To ensure this, a forward price is chosen that is
agreeable, or “fair,” to both counterparties. It is “fair” because at initiation neither of the counterparties
perceive their position to have positive value (i.e., an asset) or negative value (i.e., a liability).

Instead, the forward value will be one of the following:

■ Asset: The forward value of the counterparty that benefits from changes in the determinants of value will
now be positive (an asset).
■ Liability: The forward value of the counterparty that is harmed by changes in the determinants of value will
now be negative (a liability).

Unlike a forward, an option is not designed to have zero value at initiation. Option value is positive for the long
position (which has the right to exercise) and negative for the short position (which is obligated to transact
should the long position exercise). Hence, option value is an asset for the long position and a liability for the
short position.

The premium should be equal to the option’s value. If differences between the premium and option value
occur, this suggests that the market is mispricing the premium.

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The value of a forward is, by design, zero at initiation. Following initiation, the value of the forward from the
long forward’s perspective is:

where ft = Long forward value F = Forward price t = Valuation date T = Expiration date T − t = Years between
the valuation date and the expiration date St = Underlying asset price on the valuation date rt = Continuously
compounded risk-free interest rate on the valuation date

Hence, the short forward’s value is −ft, the negative of the long forward’s value

The forward price that is set at initiation should be equal to:

where F = Forward price t0 = Initiation date T = Expiration date T − t0 = Years between the initiation date and
the expiration date S0 = Underlying asset price on the initiation date r0 = Continuously compounded risk-free
interest rate on the initiation date

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