A. How does forward contract valuation differ from futures contract valuation?
Futures and forward contracts are viewed as derivative contracts because their values are derived from an underlying asset. The forward contract is an agreement between two parties, which are buyer and seller and they must fulfil their contractual obligations at a price established at the beginning upon the expiration date, the buyer must pay the agreed price to the seller and the seller must deliver the underlying asset to the buyer. Futures contracts have a similar definition to forward contract but futures contracts are standardized transaction.
Valuation reflects the amount of money to terminate the contract and the market Requirements to valuate these contracts when there is a default on contracts. There are some key differences in the valuations of these contracts. First of all, in case of there was a default on the forward contract, that would required the cash settlement to reduce credit exposure and forward contract risk. The forward price is equal to the spot price doubled at the favourable rate of interest at the time of the maturity date. On other words, it is the present value (PV) which equal to the future value (FV) of spot rate .So, it may traded at a premium or discount to the spot price. Moreover, that will result two position one of them will have a positive valuation, and the other will have a negative valuation. Forward contract value would be varying from market spot price through the life of the contract. On the other hand, the value of futures contract calculates as a number of contracts multiplied by size of contract which also multiplied by daily margin variation which means it not only has a futures price set at time 0 but it also has a new price at time t - 1, at time t, and at time T. Furthermore, Futures contracts valuation has some assumptions such as there is no transaction and transport costs, they do not have any basis, and opportunity cost in hedging non-existent.
B. When valuing forward contracts, explain how market position determines positive and negative values.
Under a default situation and the credit risk in a forward contract, Market position who determines positive and negative value when valuing forward contract. Valuation of forward contract calculates the credit risk by the cash settlement which would be required when there was a default in the contract. Market has a three types of positions which include long position when it own an asset (equities or funds) or hold an asset, short position if it need to buy equities or borrow funds, and neutral which is the...