Creates another risk it does not allow the investor

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Unformatted text preview: allow the investor to unwind the transaction once it is entered into. At the most the contract can be cancelled on the terms agreed upon by the counter party. Since forwards are not exchange traded they have no ready liquidity. Further it is difficult to set counter party on one¶s terms. Pricing Forward Contracts   Forwards are priced using ³Cost of Carry Model´ Depending on the nature of the carry costs associated with the asset and carry return principle the model has been modified. Carry Cost  Carry cost include the holding costs for the underlying assets. For commodities, this may refer to warehousing costs, insurance expenses, transportation cost, etc. For financial products, carry costs include financing cost like interest charges on borrowing the cash to take position in the asset. Carry Return  Carry return principle refers to the income generated by the asset. For financial product, carry return may include dividends received on shares. The major assumptions of the model      Markets are perfect i:e.,information flow is instantaneous and freely available, equal borrowing and lending rates and large number of market participants. The underlying asset are infinitely divisible. No transaction cost and brokerage fees Only one price exists thereby removing the possibility of bid (buying rate)-ask (selling rate) spread Absence of any market restrictions such as short selling, margin money, etc. Continuous Compounding       The calculation of forward prices and option prices is based on the concept of continuous compounding A=P(1+r)n A= compounded value P=principal amount r=interest rate per annum n=time period  A=P(1+ r/m)mn  r= per annum rate of interest. m= number of compounding per annum. n= number of years. For quarterly compounding m=4 For daily compounding, m=365.         A=Pe nr e is a mathematical constant whose value is 2.7183 r1=interest rate when m compounding are done r2= equivalent rate when continuous compounding is done  (1+r1/m)mn=e r2n  r2=m ln ( 1+ r1/m)  r1= m (er2/m-1) Three situations for pricing forwards depending on underlying assets  Asset with no income  Asset providing a given amount of income  Asset providing a known yield Asset with no income    The prominent example of this type of asset, giving no income, is an equity share on non-dividend basis and a deep discount bond. This is the simplest forward contract True price of a forward contract is that when no arbitrage opportunities exist  F=Ser*t Asset providing a known cash income  The examples for assets, providing known cash income, are bonds promising known coupon rate, securities with a known dividend, preference shares, etc.  F=(S-I)*ert Asset providing a known yield  A known yield refers to income expressed as percentage of the asset life, and this yield is assumed to be paid continuously as a constant annual rate of y  In this case forward price is as follows:  F=S*e (r-y)*t...
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This document was uploaded on 09/23/2013.

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