Forward Contract question

CFA Level II Derivatives
#1

Hi All - got a question that is freaking me out a bit, it would be awesome if anyone could help!

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A security is currently worth $225. An investor plans to purchase this asset in one year and is concerned the price will rise by then. To hedge this risk, the investor enters into a forward contract to buy the asset in one year. Assume that the risk free rate is 4.75%.

(here I calculated the forward price as $235.69)

Suppose that at expiration, the price of the asset is $190. Calculate the value of the forward contract at expiration. Also indicate the overall gain or loss to the investor on the whole transaction.

The answer is given as:

S[T] = $190 F(0,T) = $235.69 VT = $190 - $235.69 = -$45.69 Loss to long position = -$45.69** Gain on asset = $35 (based on $225 - $190) Net loss = -$10.69**

The bit in bold is very confusing. If I am contracted to pay $235.69 for something worth $190, why do I then need to add back the loss on the asset? Why isn’t the gain/loss on the whole transaction the same as the forward contract value, if the investor doesn’t already own the asset?

Thanks!

#2

See if this makes sense to you. I had answered this same question a while back…

Choices for investor:

Buy asset today at 225.

He entered into a forward contract -> with a price of 235.69.

Buy asset 1 year later at 190… (expiration price).

In terms of buying asset now vs. later - that he was able to buy it at expiration for 190 is a gain for him vs. buying it today. Since the price of asset dropped in the period.

It is a loss in terms of what he had to pay. He had to pay 235.69 -> due to the forward, but market price was only 190 -> so a loss of 45.69.

From <http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91096386>

#3

What’s the use of the 10.69 figure? Is the long going to default and then buy at the price at expiration?

#4

I was covering this on Monday with a Level II candidate I tutor.

The question is poorly worded. They intend for you to understand that you would have either bought the stock in the spot market at $225, or else bought it in the forward market at $235.69. So the effect of the forward transaction is a loss of $10.69, irrespective of the price of the stock at expiration of the forward.

The questions on the real exam won’t be ambiguous.

#5

Thanks all - I was hoping there would be something wrong with the question!