This preview shows pages 1–2. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
Unformatted text preview: EC3070 FINANCIAL DERIVATIVES PRESENT VALUES The Initial Value of a Forward Contract . One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset at a certain price on a certain specified future date denoted t = . The other party assumes a short position and agrees to sell the asset on the same date. The date when the contract is made is t = 0. The agreed settlement price is K = F  , where F  denotes the price at time t = 0 for a delivery of the asset at time t = . Let t = 0 be the current time so that S is the spot price of an asset. Let the current riskfree rate of compound interest be r . Then, the spot price and the forward price are related by the formulae (i) F  = S e r and (ii) S = F  e r . Here, we understand that the forward price F  must be discounted by the factor e r to equate it to the present value of S . Equally, if the sum of S were to be invested for periods under a regime of compound interest, then it would grow to S e r . To establish the necessity of the relationships, we may consider how, in their absence, there would be possibilities for arbitrage, which may be ruled out by assumption. Imagine that S e r > F  . An investor could sell the asset today for S and invest the proceeds to derive a sum of S e r at time . At the same time, he could enter a long forward contract to buy the asset at time for F  . In this way, he would derive a riskless arbitrage profit of...
View Full
Document
 Spring '12
 D.S.G.Pollock

Click to edit the document details