How to calculate Forward Price?
Alright guys, let's practice using spot rates to calculate forward prices. This involves a bit of the forward pricing model, so if you're unfamiliar with the concept, I've already made a video explaining it. Just search for "What is the forward pricing model" and once you understand that, you'll have no problem following along.
So let's get started. The interesting thing about the forward pricing model is that it gives you a timeline. For example, let's say we have a five-year time frame, and we want to calculate the two-year forward price and the three-year forward price. We can divide this time frame into two parts: the first two years and the remaining three years.
Now, at time zero, we look at the spot rate curve. We find the x-axis for the respective time period and then check the y-axis to determine the spot rate. For example, let's say the spot rate for two years is 5% and for five years, it's 8%.
Once we have these spot rates, we can calculate the discount factor. There's a specific formula for that, but I'll use the TP line to demonstrate. The crucial step is to create the equation.
Let's consider the example of two investors, A and B. Investor A buys a zero-coupon bond with a face value of 1,000. The bond only pays out at year five, so they'll receive 1,000 at that time. However, at time zero, they need to compensate the investor or bondholder, so the bond is issued at a discount.
On the other hand, Investor B enters into a forward contract where they wait for two years before buying the bond and holding it for three years. They'll receive the same payout at year five.
To calculate the forward price at time two and time five, we discount the future price back to now. The formula includes the spot rates and the time periods. The forward price for A and B should be the same since they both end up holding the zero-coupon bond at year five.
To simplify the calculations, we can use Excel. In a new sheet, we can enter the percentages, such as 5% and 8%, for the spot rates. Then, we can use formulas to calculate the discount values and the forward prices.
For example, for investor A, we can use the formula (1 + 8%)^5 to calculate the discount value. For investor B, we can use the formula (1 + 5%)^2 to calculate the discount value for the two-year period. Then, we multiply the two discount values to get the forward price.
Alternatively, we can use the timeline to calculate the investment return and then discount it back to the present to get the forward price. Both methods will give us the same result.
This kind of calculation is commonly used in the financial modeling field. If you prefer a more quantitative approach, you can use the timeline method. Personally, I find the Excel calculations to be more practical and efficient.