Deep Dive · Forwards · Lesson 5
How Forward
Prices Are Set
Big Idea
The forward price is usually not the same as today’s spot price. It is the spot price adjusted for the cost of carry — mostly interest rates, and, for a physical commodity, storage. Crucially, the forward price is set so that no one can earn a risk-free profit: it is fixed by no-arbitrage logic, not by anyone’s guess about the future.
- Forward price = spot price + cost of carry (mainly interest, plus storage for commodities).
- It is set by no-arbitrage, so no risk-free profit is possible.
The forward price is not a prediction of the future spot price — it is carry, not a forecast.
The Forward Price Is Not the Spot Price
A common assumption is that a forward simply locks in whatever the asset costs today. It does not. The forward price is fixed today, but it reflects the cost of holding the asset all the way to the delivery date — so it normally sits above or below the current spot price, not on top of it.
And it is not a bet on where the market is going. Two people can disagree completely about the future spot price and still agree on the same forward price, because that price is pinned down by no-arbitrage logic — the requirement that no one can lock in a risk-free profit — not by guessing which way the market will move.
Cost of Carry
The forward price equals the spot price plus the cost of carrying the asset to the delivery date. For a simple asset that pays no income, that carry is mainly the interest you would pay to fund holding it. So, roughly:
- Forward ≈ Spot × (1 + interest rate × time)
Take gold as a worked example. Suppose spot gold is $2,000 an ounce, the one-year interest rate is 5%, and gold pays no income. The one-year forward price is:
- Spot price: $2,000 / oz
- One-year interest rate: 5%
- Forward: $2,000 × 1.05 = $2,100
The intuition is arbitrage. If you could lock in a forward far above $2,100, you would buy gold now with borrowed money, hold it, and deliver it into the forward — repaying the loan and pocketing a risk-free profit. Everyone rushing to do that trade drags the forward back down, so it settles near $2,100.
Currency Forwards: Interest-Rate Parity
For a currency there is no storage cost — but there are two interest rates, one for each currency. The forward rate reflects the difference between them. The rule is exact:
The currency with the HIGHER interest rate trades at a forward DISCOUNT; the currency with the LOWER interest rate trades at a forward PREMIUM.
Work through an example. Spot EUR/USD is $1.10 per euro, the US one-year rate is 5%, and the euro-zone one-year rate is 3%. The one-year forward rate is:
- Spot: $1.10 per euro
- US rate: 5% · Euro-zone rate: 3%
- Forward: 1.10 × (1.05 / 1.03) ≈ $1.121 per euro
The euro is worth more dollars in the forward than at spot — a forward premium on the euro. That is exactly what the rule predicts: the dollar has the higher interest rate, so it trades at a forward discount, and the euro, with the lower rate, trades at a forward premium.
Why It Must Be This Way (No Arbitrage)
The forward price is not a matter of opinion — it is forced by the possibility of arbitrage. If a forward were priced too high, a trader could borrow cash, buy the asset at spot, carry it to the delivery date, and deliver it into the forward, repaying the loan and keeping a guaranteed profit. If it were priced too low, the mirror-image trade would do the same in reverse.
Because that profit would be risk-free, traders pile into it — and their buying and selling pushes the forward price straight back to fair value. The fair value is precisely the spot price plus the cost of carry. That is why the formula holds: any other price would leave free money on the table, and free money does not last.
Contango and Backwardation
Contango
The forward price is above the spot price. This is the usual case, because carry — mainly the interest cost of funding the asset — is normally positive.
Backwardation
The forward price is below the spot price. This happens when the asset pays income or has a convenience yield that outweighs the funding cost.
Interactive Checks
Check 1 of 3
You are explaining where a forward price comes from.
What does the forward price mainly reflect?
Check 2 of 3
Gold spot is $2,000 and the one-year interest rate is 5% (no income or storage).
Roughly what is the one-year forward price?
Check 3 of 3
Under interest-rate parity, two currencies have different interest rates.
The currency with the HIGHER interest rate trades at a:
Common Beginner Mistakes
- ❌ Assuming the forward price equals the spot price. It is the spot price plus the cost of carry, so it usually sits above or below spot.
- ❌ Ignoring interest rates. Funding cost is the main driver of a forward’s price — leave it out and the number is wrong.
- ❌ Getting the parity direction backwards. The higher-rate currency trades at a discount, not a premium.
- ❌ Thinking the forward predicts the spot price. It does not — it is carry, not a forecast of where the market will actually go.
Quick Memory Tool
- Forward price = spot + cost of carry
- Simple asset: Forward ≈ Spot × (1 + rate × time)
- Gold: $2,000 at 5% → ≈ $2,100
- Currencies: the higher-rate currency trades at a forward discount
- Set by no-arbitrage, not a forecast
Next Lesson
Counterparty Risk and Settlement — a forward’s defining hazard is that the other side must perform, with no clearinghouse behind the deal. Next we look at that risk and how a forward settles.