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CFA Level II · CFA Level II Exam

Pricing and Valuation of Forward Commitments: CFA Level II Chapter Guide

Forward commitments are contracts that bind both sides to trade later: forwards, futures, FRAs and swaps. You price them by no-arbitrage. Set the fixed price or rate so the contract starts at zero value, then revalue it later by comparing the old fixed terms with today's market terms, discounted.

What this chapter covers

This chapter covers the pricing and valuation of derivatives that commit both parties to a future transaction: forwards, futures, forward rate agreements, interest rate swaps, currency swaps and equity swaps. One idea runs through all of them. Two portfolios with the same payoffs must have the same price, otherwise an arbitrage profit exists.

Every topic asks two separate questions. Pricing means finding the fixed price or rate at initiation so the contract has zero value. Valuation means finding the contract's value at a later date, after market prices or rates have moved. Candidates lose marks by mixing these up.

The chapter links to several other areas. It builds on the derivatives basics from Level I and on the term structure and spot, forward and discount rate work in Fixed Income. Currency swaps draw on the covered interest rate parity logic from Economics. The ideas also feed into Portfolio Construction and risk management, where forwards and swaps are used to hedge. At Level II the questions sit inside item sets, so you must pull the right rates, dates and notionals from a vignette and apply the model.

Derivatives and Risk Management carries a topic weight of 5-10% of the exam, and this chapter is a large part of it. The material is formula-driven and repeatable, which makes it one of the more reliable places to gain points if you practise. Vignettes often give you spot rates, discount factors and a timeline, and the calculation is mechanical once you pick the right model. The same no-arbitrage logic also helps in Fixed Income and Portfolio Construction questions, so the effort pays back beyond this chapter.

Pricing and Valuation of Forward Commitments: topics in the order to study them

  1. 1Principles of Arbitrage-Free PricingEvery later model rests on the law of one price and replication, so learn this logic first.
  2. 2Pricing and Valuation of Forward ContractsForwards are the simplest commitment and teach the cost-of-carry idea and the price versus value split.
  3. 3Pricing and Valuation of Futures ContractsFutures build on forwards, so you only need to learn the differences, such as daily settlement.
  4. 4Forward Rate Agreements (FRAs)FRAs apply forward pricing to interest rates and prepare you for swap valuation.
  5. 5Pricing and Valuation of Interest Rate SwapsA swap is a series of forward-style payments, so it follows once you are comfortable with FRAs and discount factors.
  6. 6Pricing and Valuation of Currency SwapsThese extend the interest rate swap method to two currencies, adding exchange rates and notional exchange.
  7. 7Pricing and Valuation of Equity SwapsEquity swaps reuse the swap framework with an equity return leg, so they are easiest to learn last.

How to prepare Pricing and Valuation of Forward Commitments

This chapter rewards a method you can repeat under time pressure. Learn the logic once, then drill the calculation steps until they are automatic.

  1. Start with replication. Write down, in your own words, how you would build the same payoff with a spot position and borrowing or lending, and why that fixes the price.
  2. Keep two columns in your notes for every instrument: how to find the fixed price or rate at initiation, and how to find the value after initiation. Never mix them.
  3. Practise with discount factors. Convert spot rates to discount factors, then use them to find forward prices, swap fixed rates and swap values.
  4. Set up a timeline for every question. Mark the dates, the payments, which leg pays what, and from whose perspective you are valuing.
  5. Do full item sets, not isolated formulas. Practise finding the needed rates and dates in the vignette and ignoring the extra data.
  6. Check your sign and direction before answering. Ask whether the long or the short, the fixed payer or the receiver, has gained or lost.
  7. Revise by redoing questions you got wrong after a few days, and note the exact reason, such as the wrong rate, wrong period or wrong direction.

Common mistakes in Pricing and Valuation of Forward Commitments

  • Confusing forward price with forward value.

    Fix: Ask if the contract is being initiated or already exists. At initiation, find the price. After initiation, find the value as the difference between present values.

  • Using the wrong rate or period from the vignette.

    Fix: Label each rate on your timeline. Use spot rates or discount factors for present values, and check the compounding and the day count.

  • Treating futures exactly like forwards.

    Fix: Remember that futures settle daily and the value resets to zero. Equal prices hold only under certain conditions, such as non-stochastic interest rates, so read the question for what it assumes.

  • Getting the direction wrong in swaps and FRAs.

    Fix: Write down the party whose value you need. A fixed payer gains when rates rise, and a fixed receiver gains when rates fall.

  • Ignoring the notional exchange in currency swaps.

    Fix: Include the final notional in each currency's cash flows and convert both legs at the spot rate on the valuation date.

  • Mishandling the equity swap reset.

    Fix: Value the equity leg as the notional right after a reset, and use the current index level relative to the last reset between reset dates.

Last-day revision: Pricing and Valuation of Forward Commitments

  • Arbitrage-free pricing: two assets or portfolios with identical payoffs must have the same price.
  • Forward price at initiation is set so the contract value is zero for both sides.
  • Forward price on an asset with no income or cost of carry: F₀ = S₀ × (1 + r)ᵀ.
  • Income such as dividends lowers the forward price, and storage costs raise it.
  • Forward value before expiry, for the long position: V_t(long) = S_t − PV(benefits) + PV(costs) − F₀ ÷ (1 + r)^(T − t). The short's value is the negative of this.
  • Futures are marked to market daily, so value resets to zero after each settlement.
  • An FRA fixes a rate for a future borrowing period, and its payoff is discounted from the end of the period back to the settlement date.
  • Swap fixed rate at initiation makes the present value of fixed payments equal the present value of floating payments.
  • A plain vanilla swap's fixed rate can be found from discount factors as (1 − final discount factor) ÷ sum of discount factors.
  • After initiation, from the fixed receiver's view, swap value = PV of the old fixed payments (at the contract rate) minus PV of the new fixed payments (at the current market swap rate). For the fixed payer, reverse the sign.
  • A currency swap involves the exchange of notional at start and end, and each leg is valued in its own currency's rates before converting at spot.
  • An equity swap pays the equity return on one leg against a fixed or floating rate on the other, and the equity leg resets to notional on each reset date.

Pricing and Valuation of Forward Commitments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Pricing and Valuation of Forward Commitments: frequently asked questions

What is the difference between pricing and valuation of a forward commitment?

Pricing means setting the fixed price or rate at the start so the contract has zero value. Valuation means finding what the contract is worth later, after market prices or rates have changed. The exam tests both, so read which one is asked.

In what order should I study this chapter?

Begin with arbitrage-free pricing, then forwards, futures and FRAs. After that, study interest rate swaps, currency swaps and equity swaps. Each topic reuses the logic of the one before it.

Do I need to memorise many formulas for forward commitments?

You need a small set, but it is more useful to understand the replication logic behind them. Once you see why a formula holds, you can rebuild it and adapt it to different cash flows, dates and perspectives in a vignette.

How are these topics tested at Level II?

They appear in item sets, where a vignette gives rates, dates and notionals and you answer four questions from it. You need to find the right data and apply the right model, not just recall a formula.