CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
At initiation of a forward contract on an asset that pays no income and has no storage costs, the forward price is most likely set so that:
The forward price is set so the contract has zero value to both parties at initiation. It is derived from no-arbitrage pricing, spot compounded at the risk-free rate, rather than from expected spot prices, and no cash changes hands when the forward is initiated.
- Athe contract has a value of zero to both partiesCorrect
- Bthe long party pays the spot price to the short party
- Cthe forward price equals the expected future spot price
Explanation
A forward contract is entered at no cost, so the forward price is set to make its initial value zero to both counterparties. The forward price comes from no-arbitrage (spot compounded at the risk-free rate), not from the expected future spot price, and no payment of the spot price occurs at initiation.
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