Off-market Forward Contracts
As we know, a forward contract is a bilateral agreement between a buyer and seller to exchange a certain quantity and quality of an asset for a pre-determined price at a specified future date. A forward contract does not involve an exchange at the beginning of the contract, however, on the future date both the parties are obligated to fulfil their commitments. At the beginning the contract has zero value.
An off-market forward contract is a special case of forward contract and the initial contract price is not zero, i.e., the price is not set equal to the no-arbitrage price. Due to this reason, the long or short party will have to make a payment to the counterparty to offset the initial price difference. In effect, you are receiving or paying a premium to enter into the forward contract. The party who has a positive value will pay this value to the counterparty that has negative value.
Let’s say that the effective interest rate is 10%, and the S&P500 index is at 1,500. Let say there is a 1-year forward contract at a forward price of 1,200.
A standard forward contract would have a forward price of 1,500*1.1 = 1,650. Since this forward contract has a price of 1200, it’s an off-market forward contract.
The payoff from this forward contract would be (1650 – 1200)/1.1 = 409.09. This is the premium the long party will be willing to pay to enter into this contract.
If the forward price was, say 1800, then the buyer would need to receive (1650 – 1800)/1.1 = 136.36 to enter into this contract.