When the VALUE of the contract is negative, does this mean a loss or gain to the short side?
Reading 51, EOC Q1 states “Because the value is negative, the payment is made BY the short to the long.” So, a loss to the short side.
EOC Q3 states, in reference to a negative value, “this represents a GAIN to the short position.”
It seems like a negative value of the forward contract means that the forward price is high relative to the spot price - so this should mean a LOSS to the party who is LONG the contract (and contracted to buy at that price)…right?
The question asks you to calculate the value of the contract at inception (security sells for $1000 today, forward price $1100 in one year, i = 6.75%.)
The answer:
V0(0,T) = $1000 - $1100/(1.0675) = -$30.44
Because the value is negative, the payment is made by the short to the long.
Since the forward price is high relative to the spot, meaning a negative value, shouldn’t the SHORT side benefit and thus receive the payment?
That’s a tricky question and the key is that the question states it’s an “Off-market forward”. The solution does not explain it very well and can lead to confusion.
In the case of an off-market forward, a payment needs to be made at the beginning of the trade to ensure we begin the trade on fair footing.
In this case our forward price is overvalued and is therefore not arbitrage free, therefore if we initiated the trade at this off-market value, the LONG would be down (-30.44).
To bring us all square at inception, the short pays 30.44 to the long.
But it always stands (even in this case) that given the formula for Value from the Long’s perspective, a positive is positive Market Value for the Long and a negative is negative MV.
Even in this case, the negative meant that the Long began the trade with negative MV, which is why the compensation was required.
Why would anyone issue or want to own an off market forward (instead of a regular one), when even when it is off market - payment is made to nullify the advantage to one party at inception?