The spot price of a market index is 1085 A 9month forward co

The spot price of a market index is $1,085. A 9-month forward contract on this index is priced at $1,170. What is the profit or loss to a short position if the spot price of the market index is $1,095 on the expiration date?

Solution

Question: The spot price of a market index is $1,085. A 9-month forward contract on this index is priced at

                $1,170. What is the profit or loss to a short position if the spot price of the market index is $1,095

               on the expiration date?

Answer: Suppose that Y wants to buy the buy the market index 9 months from now. At the same time, suppose

               that X currently owns the same market index with spot price at $1,085 that he wishes to sell 9 months

               from now. Both X and Y enters into a forward contract with each other and both agree on the sale price

               of $1,170 that Y will pay to X 9 months from now.

              Since X and Y have entered into a forward contract. Y, because he is buying the underlying article,

              is said to have entered a long forward contract or we say Y is in long position. On the other hand,

               X will have the short forward contract or short position.

              At the end of 9 month that is at the expiration date, the spot price of the market index is given as

              $1,095. Then, because Y is obliged to buy from X for $1,170 hence Y will make a loss of $ 75

              Since the difference between the spot price of the market index on expiration date and the agreed

              forward contract price = $1170-$1095 =$75. On the other hand X, the person in short position will

              earn the profit of $75 in excess to the spot price of the market index on the expitration date.